Emerging Market Finance

Spring 2005

Professor J.P. Mei
New York University
All Rights Reserved

Course Description

The course covers essential elements of emerging financial markets, securities and how the securities are valued and traded. The perspective is that of the investment manager, responsible for investment portfolios of insurance companies, banks, pension funds, mutual funds, endowment funds, and personal trusts. What we cover in this course has obvious implications for asset allocation and security selection strategies. We discuss several outstanding problems of emerging market investment, including political risk, currency risk, speculative craze, market manipulation, different accounting rules, and performance measurement. We will also cover emerging market security valuation, portfolio diversification, project finance, and venture capital. The objective here is to train highly skilled financial analysts and managers with strong theoretical background and practical knowledge about emerging markets.

Background Reading: Malkiel and Mei, Global Bargain Hunting (Touchstone 1998).(Out of Print, but you may get it from Amazon.com)

Internet Resources:

1.Emerging Market Corporate Finance by Prof. Cam Harvey (I have incorporated some of Prof. Harvey's material in my course)

I’ve also used some teaching material from Prof. Zhiwu Chen’s course at Yale

It is most important that students keep up to date with the reading for the course.

The grade will be based on a group project (70%) and a mid-term (30%). The group project will be conducted by a group of 5 students, which will focus on the construction and marketing of a country fund or writing a business plan.

1)    For country fund, it will include writing a prospectus, a quarterly report, and a powerpoint document for a “road show”. Towards the end of the term, every group is expected to do a road show, i.e. convince an investment committee made of your peers and myself that the fund is a good long term investment. Every student needs to make 4-5 minutes presentation on behalf of the team. The grade will be based on the prospectus, the quarterly report, and the performance at the “road show”.

2)    For Business plan, it will include a plan report and a powerpoint document for a “road show”. Towards the end of the term, every group is expected to do a road show, i.e. convince an investment committee made of your peers and myself that the plan is feasible. Every student needs to make 4-5 minutes presentation on behalf of the team.

Lecture 1: Understanding the Emerging Process

We will begin by ask the fundamental question: what makes a country grow? Then we will study the brief history of market reform in the world.

1.    The Myth of Asia's Miracle by Paul Krugman(Required)

2.    The Submergence of the Japanese Economy: Some Unique Spmptoms (Required)

3.    Ramesh Thakur, " China is outperforming India", International Herald Tribune, Jan. 7, 2003

4.    William Megginson and Jeffrey Netter, "From State to Market: A Survey of Empirical Studies on Privatization" Journal of Economic Literature 2001, forthcoming. PDF.

5.    See Bill Megginson's other privatization papers and data appendices. Goto site.

Lecture 2: Measuring Return And Volatility.

We will begin by discussing why emerging market provide the great growth opportunities. We will then study the issues of measuring Emerging Market equity returns, return distributions, and the general evidence of market volatility. We will examine short- vs. long-term correlations of various different markets. We will also study the relationship between risk and returns. Then, we will take a close look at the volatility of market valuations and how this volatility may affect asset allocation. Finally, we will discuss alternative measurement of risk and the impact of speculation on volatility.

Assigned readings:

1.    Bekaert, Erb, Harvey, and Viskanta,"Distributional Characteristics of Emerging Market Returns and Asset Allocation," with Geert, Journal of Portfolio Management (1998), Winter, 102-116. PDF(Required)

2.    Sheldon Gao, Dow Jones: “China Stock Market In A Global Perspective(Required)

3.    William Goetzmann and P. Jorion, "Re-emerging Markets"

4.    Ghysels, Eric and Mouna Cherkaoui, "Emerging Markets and Trading Costs," (a case study of the Casablanca Stock Exchange), Pennsylvania State University and CIRANO.

5.    Silber, William L., 1991, “Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices,” Financial Analysts Journal, July-August 1991, 60-64.

6.    Bris, Arturo, William Goetzmann and Ning Zhu, "Efficiency and the Bear: Short Sales and Markets around the World," Yale School of Management

Lecture 3: Currency Crisis

These lectures cover issues related to exchange rate determination. We will examine currency market volatility and contagion, which will be followed by a microeconomic analysis of the Asian financial crisis. Then, we will cover some structural problems in EM economies.

Assigned readings:

1. Michael Pomerleano, 1999, The East Asia Crisis and Corporate Finance, Emerging Market Quarterly.PDF(A very good article. Required)
2. Stijn Claessens, Simeon Djankov, and Giovanni Ferri, 1999, "Corporate Distress in East Asia: Assessing the Impact of Interest and Exchange Rate Shocks" Emerging Markets Quarterly 3, 2. 8-14. PDF

Lecture 4: Forecasting Currency Crisis and Risk Management

We will discuss various indicators for exchange rate forecasting. We will present actual data on 11 disguised countries and asks students to consider which is most likely to experience a crisis. We will also study currency hedging from both corporate finance and portfolio investment perspective.

Assigned readings:
1. HBS Case: Currency Crises by Robert E. Kennedy and Brian P. Irwin(Required)
2. Case Study: Identifying, measuring, and hedging currency risk at Merck, JACF(Required)

Lecture 5: Political Risk and Financial Crisis

This lecture will cover a brief history of submerged markets (e.g. Russia, Argentina, Mexico) and survivorship bias. We will also examine the corruption issue. We will outline major political risk in the past and present. Finally, we will cover issues related to measuring and insuring political risk.

Assigned readings:

1.    "Global Bargain Hunting" by Burton Malkiel and J.P. Mei (Touchstone): Chapter 3 & 4

2.    Jianping Mei and Limin Guo, 2002, "Political Uncertainty, Financial Crisis, and Market Volatility".(Required)

3.    Campbell R. Harvey, "Expected Returns and Volatility in 135 Countries" with Claude Erb and Tadas Viskanta, Journal of Portfolio Management Spring 1996, pp. 46-58. (P36) PDF

4.    Wilshire Associates, "Permissible Country Equity Investment Analysis and Recommendations", April 1999. PDF

5.    Country Risk Ratings from PRS Group

Lecture 6: Market Manipulation and Capital markets Regulation

  1. Zhou and Mei, “Behavior Based Manipulation” (Required)
  2. Rafael La Porta; Florencio Lopez-de-Silanes; Andrei Shleifer; Robert W. Vishny, "Law and Finance", The Journal of Political Economy, Vol. 106, No. 6. (Dec., 1998), pp. 1113-1155. (Required)
  3. Morck, Randall, Bernard Yeung, and Wayne Yu.(2000)."The Information Content of Stock Markets: Why Do Emerging Markets have Synchronous Stock Price Movements?" Journal of Financial Economics, PDF.
  4. Utpal Bhattacharya and Hazem Daouk , "The World Price of Insider Trading ", Journal of Finance, 2000. 
  5. Rafael La Porta; Florencio Lopez-De-Silanes; Andrei Shleifer; Robert W. Vishny, " Legal Determinants of External Finance", The Journal of Finance, Vol. 52, No. 3. 

Lecture 7: Corporate Governance Issues in EM

This lecture will examine corporate governance issue and corruption issue and how they may affect investment value and corporate finance.

Assigned readings:

1.    "Global Bargain Hunting" by Burton Malkiel and J.P. Mei (Touchstone): Chapter 3 & 4

2.    Stijn Claessens and Joseph P.H. Fan, 2002, Corporate Governance in Asia: A Survey, PDF

3.    Laura Cha, " The Future of China's Capital Markets and the Role of Corporate Governance" Word File

4.    Grishchenko, Litov and Mei, Private Information Trading and Corporate Governance In Emerging Markets, PDF

5.    Campbell R. Harvey, "The effect of capital structure when expected agency costs are extreme," with Karl Lins and Andrew Roper, PDF

6.    Robert Korajczyk and A. Levy, Capital structure choices, PDF

Lecture 8: The Top-Down, bottom-up, and Momentum Strategies

This lecture will begin by studying various ways of gauging valuation levels of emerging markets. We will discuss the Smith Barney Global Asset Allocator Model and its performance. The application of this model in a single market is also discussed. We will also demonstrate how momentum strategies may be applied to achieve market outperformance.

Assigned readings:

  1. Geert Rouwenhorst, "International Momentum Strategies" Journal of Finance 53, 1998, 267-284. PDF. (Required)
  2. E. Fama and K. French, “Value and Growth: The International Evidence”, Journal of Finance, December 1998, PDF
  3. "Valuation in Emerging Markets", McKinsey Quarterly 2000, number 4. PDF.
  4. Tsingtao Breweries: Valuation with Changing ROE by Aswash Damodaran 
  5. Emerging Market PE Ratios: 2000 by Aswash Damodaran 
  6. Campbell R. Harvey, Stock Selection in Emerging Markets (PM24) PDF

Lecture 9: Cost of Capital and Asset Valuation

We will discuss the determination of cost of equity capital for Emerging Market investment, followed by a review of valuation techniques used to assess cross-border investments. We will then cover the discounting of free cash flows with a weighted average cost of capital and the use of adjusted present value.

Assigned readings:

1.    Kent Hargis, The Goldman Model of Equity Cost of Capital, PDF(Required)

2.    Campbell R. Harvey, "The International Cost of Capital and Risk Calculator," PDF

3.    Rene Stulz, The globalization of equity markets and the cost of capital, PDF.

4.    Ravi Jagannathan and I. Meier, Do we need the CAPM for capital budgeting?, PDF.

Lecture 10: Credit Risk Measurement.

This lecture extends the z-score model to estimates the credit quality of emerging market corporate debt. We will then show how fixed income securities work and how they are valued. We will focus on the Brady bond market. We will then examine the relationship between credit risk and bond yields.

Assigned readings:

  1. Emerging Market Corporate Bonds—A Scoring System, by Ed Altman (Required)
  2. Risk Premiums for Other Markets, Download
  3. Moody's Moody's, S&P Ratings, PDF

Lecture 11: Emerging Market IPO

We will study the listing EM company shares through an American Depositary Receipt program in the US market and their pricing issues.

Assigned readings:

  1. Andrew Karolyi, Why Do Companies List Their Shares Abroad? (an excellent Survey of the Evidence and its Managerial Implications), Volume 7, Number 1, Salomon Brothers Monograph Series, New York University, January 1998, 60 pages.
  2. HBS Case: Huaneng Power International, Inc.: Raising Capital in Global Markets, by Steve R. Foerster, Andrew Karolyi, and Jerry White.

Lecture 12: Financing of the Mozel Project

Mozel is $1.4 billion aluminum smelter project in Mozambique. This case is designed for people with an interest in capital investments in emerging markets. It presents an extreme example of political risk in a developing country and shows how project sponsors attempt to mitigate the risks through project selection, structuring, and insurance.

Assigned readings:

1. HBS Study: An Overview of Project Finance (HBS: N9-200-028) PDF(Required)
2. HBS Case: Financing the Mozal Project, by Benjamin C. Esty and Fuaad A. Qureshi
3. Ben Esty's excellent project finance portal

Lecture 13: Infosys: Financing an Indian Software Start-Up

This case describes the financing and growth of Infosys, an Indian software start-up. The company must decide whether it should seek to also list its shares on a U.S. stock exchange and, if yes, whether to list on NASDAQ or NYSE.

Assigned readings:

1: HBS Case: Infosys: Financing an Indian Software Start-Up, by Walter Kuemmerle and William J. Coughlin

Lecture 14: Bank Risk Management and Financing

We will begin by discussing the financial crisis in many EM banks. We will outline the major risks faced by these banks. In managing these risks, we will discuss capital adequacy, risk based capital ratios, deposit insurance, and other liability guarantees. We will cover liquidity and liability management, product and geographic diversification, risk management using derivatives, and securitization.

Assigned readings:
1. NYU Case: ICICI Debt Financing

Lecture 15. Real Options in Emerging Market Investment 

  1. "The Real Power of Real Options", McKinsey Quarterly 1997 No. 3: PDF(Required)
  2. "Making Real Options Real", McKinsey Quarterly 1998 No. 3: PDF.
  3. Black-Scholes options pricing software, Download excel.
  4. Campbell R. Harvey, Identifying Real Options, View HTML(Required)

Group Project I: Building a Country Fund

(You Should Start Working Now!)

In this course, you will build a country fund with a group of your classmates. Here are the steps you should take:

a) Begin work immediately by forming your groups. Start Investing $50 million paper money right away by building a country portfolio. This will help you establish a track record for a quarterly report.

b) I would advise you to work closely with other students in the class. They might have some connections and interesting ideas.

c) Find a most efficient way of obtaining data, via express mail, fax, or email.

e) When you start, use the following checklist:

1: Collect Press Information on the Country
2. Collect Macroeconomic, Social, and Political Condition of the country over the last ten years.
2: Collect data on various country indices. (Information on various indices: Dow Jones, MSCI, S&P Emerging Market Indices)
3: Collect Market Data on price, dividends, trading volume, and earnings forecast.
4: Collect data on debt ratings and yields on similar bonds.
5: Collect list of Investible stocks.
 

Deadline: You should deliver to me the following on

1.    2/22: An email (jmei@stern.nyu.edu) notifying me which country you select, names of your group members, group leader and his/her email. Also send me your portfolio position, based on Jan 31 closing prices. Please use the following file name to report your position: CountryName-leader name-012703.xls (8 points)

2.    3/22: A first draft of fund prospectus. (8 points)

3.    4/5: A first draft of Macro/Industry/company analysis for road show document. (8 points)

4.    4/12: A first draft of quarterly report, using closing price on April 2nd for constructing your quarterly report. (8 points)

5.    4/16: PowerPoint presentation slides for road show (8 points)

6.    5/3: Road Show (20 points)

7.    5/10: Final version of Prospectus, quarterly report, road show document, and powerpoint slides. (10 points)
 

The prospectus should include the following: (Sample Prospectus)

1.    Fund name, Investment objective

2.    Principal Investment Strategies

3.    Principal Investment Risks

4.    Performance Summary (So far)

5.    Average Daily Return

6.    Benchmark Daily Return

7.    A report on fund expenses (based on some reasonable assumptions and your trading cost), similar to that on page P-34

8.    Important notice on taxes and fund transaction

The Macro/Industry/company analysis should include the following: (Sample)

1.    Executive summary: why this country?

2.    Macroeconomic analysis: GDP, Trade, Currency, etc

3.    Industry analysis and Stock valuation (Sample Study on China Market)

4.    Benchmark analysis: Bechmark Industry weights, why do you use this particular benchmark? What is its strengths and weaknesses?

5.    Fund Performance so far.

6.    Reasons for investing or not.

7.    List of investible stocks and basic information, such as name, market cap, float, shares outstanding, exchange

The quarterly report should include the following: (Sample Report)

      Performance

      The manager overview

      Investment changes (1/23/03 to 4/2/03)

      Investment

      Financial Statement

      Notes to fianacial statement

 Or Group Project II: International Business Plan

(You Should Start Working Now!)

In this course, you may also develop a business plan with a group of your classmates. Here are the steps you should take:

a) Begin work immediately by forming your groups. Find a product or a business that is under developed in certain markets/countries in the world.

b) I would advise you to work closely with other students in the class. They might have some connections and interesting ideas.

c) Find a most efficient way of obtaining data, via express mail, fax, or email.

e) When you start, use the following checklist:

1: Collect pricing information about the product or service
2. Collect costs of labor, production, technology, intellectual property rights, amount investment and other related startup costs (if any)
3: Collect industry competitive information
4: Provide financial analysis as well as major risk analysis
5: Provide Development, Financing, Marketing and other execution Strategies.

Deadline: You should deliver to me the following on

1)    2/23: An email (jmei@stern.nyu.edu) notifying me what product/business you select, names of your group members, group leader and his/her email. (8 points)

2)    3/22: A first draft of your B-plan introduction. (8 points)

3)    4/5: A first draft of cost and profit analysis based on costs of labor, production, technology, intellectual property rights, amount investment, and pricing  information. (8 points)

4)    4/12: A first draft of Country/Industry/company analysis for road show document. (8 points)

5)    4/26: PowerPoint presentation slides for road show (8 points)

6)    5/3: Road Show (20 points)

7)    5/10: Final version of Prospectus, quarterly report, road show document, and powerpoint slides. (10 points)

Data resources

1. Global Macroeconomic and Financial Policy Site by Nouriel Roubini

2. J.P. Mei's "Emerging Market Finance" Data Source