Factors Affecting Risk Premium Of Emerging Market

This document is authorized for use only by Yen Ting Chen in FInancial Markets and Institutions taught by Nawal Ahmed Boston University from September 2014 to December 2014.

Over the years the global economy has seen a rise in so called ‘emerging markets’. These are developing economies which have exceeded economic performance in respect to their developing counterparts. These economies are newly industrialized and are on their way to becoming developed economies but have not yet reached that status. The more common and likely heard developing economies consists of BRIC (Brazil, Russia, India, and China) followed by Mexico, South Korea, Turkey, Saudi Arabia, and Indonesia. Developed nations (MEDC) include the westernised countries such as the U.S, the U.K and Japan. In 1999, Dr. Kvint published this definition: "Emerging market country is a society transitioning from a dictatorship to a free-market-oriented-economy, with increasing economic freedom, gradual integration with the Global Marketplace and with other members of the GEM (Global Emerging Market), an expanding middle class, improving standards of living, social stability and tolerance, as well as an increase in cooperation with multilateral institutions" This essay will locate the common characteristics that emerging markets share.

China had a GDP per capita level similar to Zambia, less than half of the Asian average and was lower than two-thirds of the African average at the outset of the reforms in 1978 (Eckart, 2016). China was poor. Since then, China has grown exponentially experiencing nearly 10% GDP grown per year until 2014 raising GDP from 155 current US Dollars in 1978 to 7,590 US Dollars in 2014 (Eckart, 2016). China, who accounts for 18% of the world’s population, was able to lift 800 million people out of poverty and growth in the middle class. This document will examine China’s financial and currency markets.

The stock market is like a playground for business. Business’s either collapse or succeed when stock prices go up or down depending on the market at the time; it’s like gambling. The stock market is a medium for business’s and investors who want to be part

Many Chinese conglomerate firms may operate an inefficient internal capital market and effectively subsidize FDI (Liu, 2005).

The government of china is very keen to encourage foreign investors, because foreign companies are regarded as relatively good corporate

China’s equity market has been at the epicentre of the weakness in risky asset prices. The irony is that underlying Chinese economic activity has probably improved since last August’s devaluation. The focus of financial markets has, however, been firmly on the torrid deflationary plight of the industrial sector. Despite official denials, devaluation is viewed as a potential policy remedy. Weak currencies are usually bullish for equity markets. Why is this not currently the case for China? Domestic financial conditions have tightened due to the reduction in foreign exchange reserves as the People’s Bank of China (PBoC) attempts to stem capital flight. It appears, therefore, that foreign exchange intervention is not being sterilised by the central bank via money market operations. This has resulted in tighter money market rates and consequently bad for equities. Meanwhile, tighter domestic financial conditions have not yet

In today’s world, economic power is the prime moving force in determining how much a country can produce, buy, or sell their products or services. One notable economic powerhouse is China. Over the years, the Chinese business climate has grown from a centrally planned economy to a socialist market economic system. Having this new economic system gives foreign investors many market opportunities. However, one must not forget the differences in political and cultural environment that can create risk and uncertainty for foreign investors. According to a 2010 survey by the US-China Business council, companies are reporting strong growth and profitability despite the economic downturn. China has a large market and their purchasing power is ranked second in the world. Although companies are profiting, there are fourteen business issues in China. They are: administrative licensing barriers, competition with PRC state-owned enterprises or national champions, intellectual property rights enforcement, cost increases for labor and raw materials, restrictions on foreign investments, restrictions on market access in services companies, transparency, government procurement standards and conformity assessment, protectionism risks in China, lack of equal treatment from domestic companies, lack of consumer awareness/understanding about products, miscommunications due to language barriers and ethical issues, and the difference in human resource practices. In the United States, managers tend

2016 is said to be “Record Breaking Year” for Chinese Investors. According to Forbes News, five major acquisitions of U.S companies and stakes totaled up to 28.16 Billion dollars. Yet, this was only a quarter of China’s entire outward investments in 2016. Many foreign firms suppose that China’s oversea merging and investing in next decade will reach tremendous amount, but it will not occur as they expected depending on Emma Johanningsmeier’s current event reports on Wall Street Journal about “New Chinese Regulations and wary foreign governments hamper M&A investors” in august 2017.

After the economic reforms of 1978, China gradually became the manufacturing hub of the world and its GDP catapulted from 214 billion USD and 9th in the world to almost 11 trillion and 2nd in the world in 2015 (focus economics, 2016). China’s financial system has managed to sustain this rapid economic growth for many years, mostly through the appropriate allocation of capital (Yan, 2013).

Investing in emerging markets offer tempting advantages to investors. The volatile economies of countries considered to be in this category have a potential for extraordinary returns. A caveat to investors considering opportunities in emerging markets are the presence of unstable governments, the chance of nationalization, poor property rights protection, and large swings in prices. Emerging markets are far from a sure thing. But, despite high individual risk, emerging markets can reduce portfolio risk. The volatile economies of these countries have such low correlations compared to the domestic market that they actually provide the greatest degree of diversification.

It has experienced fast growth since the open door policy in 1978, especially over the past decade. According to Turner, G & Tan, N & Sadeghian, D (2012, p.53), the total assets in the banking system (including assets in Chinese banks’ foreign branches and subsidiaries) was around 240% of GDP at the end of 2011, a substantial increase from about 200% in the early 2000s. The growth is mainly attributed to an increasing domestic demand for banking services and activities associated with economic development. As a result, China did not suffer severely from the 2008-2009 global financial crisis. The top five banks in China by size, the big four mentioned previously and the Bank of Communications (BCOM), control around half of Chinese banking system assets and deposits (Turner, G & Tan, N & Sadeghian, D 2012, p.53). The ‘Big Five’ also account for nearly 50% market share in the banking industry. These leading banks are mostly state-owned and partially privatised through listing on the Hong Kong stock exchange (Turner, G & Tan, N & Sadeghian, D 2012, p.53). Compared with the stock markets, the banking system in China has considerably greater importance due to its size (Allen, F, Qian, J & Qian, M 2005, p.70) and the structure of its economy. However, the stock markets in China are considered to be comparatively more efficient than the banking system within the country

China’s financial system has gone through several rounds of reforms in the past decades and yet still

An extensive amount of research from a variety of advanced countries has documented the macroeconomic effects on stock price indexes, with a majority of economists agree on the significant influence (Masuduzzaman, 2012; Chaudhuri and Smiles, 2004; Cheung and Ng, 1998; Chen, Roll and Ross, 1986; Fama and Schwert, 1977). However, in developing countries, while some research on the exploration of the relationship has been conducted, the conclusions are controversial (Robert, 2008; Wongbangpo and Sharma, 2002). Unlike the developed economies tightly linked together, the emerging economies are separated to some degree. This phenomenon indicates that generally, it is the specific local factors that affect the particular countries, rather than

The phenomena behind equity risk premium discussion for 35 years, was first took place in Robert J. Schiller’s work done on volatility of equity prices. The research conduct by Schiller (1982), highlighted the difficulty of explaining the historical volatility of stock prices. The results of Shiller’s paper stunned the profession at first as most of economists felt discount rates were close to constant over time. The intuition behind the unpredictability of volatility, later named volatility puzzle by scholars who have studied this paradox as well. Just after 3 years from Schiller work on historical volatility, Mehra and Prescott (1985) introduced the equity premium puzzle. It is mainly based on the lack of evidence for a high risk premium in terms of consumption growth. In other words, investors require and have high returns which have low covariance with consumption growth. Using Schiller’s data collected on the volatility puzzle, they have found out that between 1889 and 1978, the consumption growth rate, the indicator for opportunity cost of investors is insufficient to explain 6% risk premium. Moreover, it was so high that the findings suggested only a risk premium of 0.35% on top of the risk-free rate. Behavioural finance approached this puzzle based on preference of investors. The decision making process of investors on investing on equities and why do they require high risk premium and fear equities this much. One of the leading papers on the