Risks You Should Consider Investing In Emerging Markets

Emerging markets usually appear to provide new investment opportunities, their elevated economic growth rates giving higher expected returns. However, there are also important risks that you have to consider. Check them out below.

Foreign Exchange Rate Risk

Foreign investments in stocks and bonds usually produce returns in the domestic currency. Therefore, investors are required to convert this local currency back into their domestic currency.

That means currency fluctuations can hugely affect the total return of the investment. For instance, if the local value of the stock increased 5 percent, but the currency, say, the Brazilian real, decreased 10 percent, the investor will experience a net loss in his total returns when selling and converting back to US dollar.

Non-Normal Distribution

North American market returns somewhat follow a pattern of normal distributions. As a result, financial models can be used to price derivatives and accurate economic forecasts about the future of the equity prices.

On the flip side, emerging market securities cannot be valued by using the same kind of mean-variance analysis. Additionally, because emerging markets are undergoing constant changes, it is almost impossible to use historical information in order to draw proper correlations between events and returns.

Insider Trading Restrictions

Even though most countries claim to implement strict laws prohibiting insider trading, none has proven to be as strict as the United States in terms of prosecuting such activities. 

Insider trading and other forms of market manipulation give rise to market inefficiencies, whereby equity prices will largely deviate from their perceived intrinsic value. This kind of system can be subject to high levels of speculation, and can also be heavily controlled by those who are holding privileged information.

Lack of Liquidity

Emerging markets are in general less liquid than those that are found in developed economies. This market quality results in higher broker fees and a higher level of price uncertainty. Investors who are trying to sell stocks in an illiquid market face huge risks that their orders will not be filled at the target current price, and the transactions will only go through at an unfavorable level.

On top of that, brokers will charge higher commissions since they have to exert more diligent efforts to find counterparties for trades. Illiquid markets prevent investors from getting the benefits of quick transactions.

Difficult Raising Capital

A poorly developed banking system will impede any effort from firms that want to have access to financing that is needed to grow their businesses. Attained capital will usually be issued at high required rate of return, increasing the company’s weighted average cost of capital (WACC).

The major issue with having a high WACC is that fewer projects will reap a high enough return to yield a positive net present value. Thus, financial systems found in developed countries prohibit companies from undertaking higher levels of profit-generating projects.

Corporate Governance

An effective corporate governance structure within any organization is correlated with positive stock returns. Emerging markets sometimes have weaker corporate governance systems, whereby management, or even the government, has a greater authority in the firm than shareholders.

Also, when countries impose regulations on corporate takeovers, management doesn’t have the same level of incentive to perform in order to maintain job security.

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