Victor Silverio Posadas Hernandez

Stock Market Anomalies

The Latin American Evidence

Deutscher Universitats-Verlag
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Dissertation Universitat Frankfurt am Main, 2004

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Vorwort der Herausgeber
Das betriebswirtschaftliche Gebiet Finanzierung hat sich in den vergangenen dreifiig
Jahren im Hinblick auf die Abgrenzung von anderen wirtschaftswissenschaftlichen
Teildisziplinen, aber auch im Hinblick auf die Forschungsinhalte und die For-
schungsmethoden stark gewandelt. Finanzierung wird heute meist, dem ameri-
kanischen Gebrauch des Begriffes „Finance" folgend, als Oberbegriff fiir die Gebiete
Untemehmensfinanzierung, Investition und Bankbetriebslehre verwendet. Diesen drei
Gebieten ist gemein, da6 die Funktionsweise der relevanten Geld-, Kapital- und De-
visenmarkte von zentraler Bedeutung ist. In der Forschung wird ublicherweise mit
mehr oder weniger stark formalisierten Modellen in einem ersten Schritt versucht,
Hypothesen iiber die betrachteten Sachverbalte abzuleiten, in einem zweiten Schritt
werden diese Hypothesen dann empirisch uberpruft, d.h. mit der Realitat konfrontiert.

Gemessen am zeitlichen Aufwand der beteiligten Wissenschaftler und am Umfang der

vorgelegten Arbeiten hat im Gebiet Finanzierung die empirische Forschung in den
vergangenen Jahren betrachtlich an Bedeutung gewonnen. Dabei haben die EDV-
maBige Verfugbarkeit von Daten und die verbesserten Moglichkeiten ihrer Verarbei-
tung eine wichtige Rolle gespielt.

In die vorliegende Schriftenreihe sollen Dissertationen und Habilitationen aufgenom-

men werden, die zur empirischen Finanzmarktforschung (im weitesten Sinne) einen
wichtigen Beitrag leisten. Autoren bzw. die sie betreuenden Hochschullehrer werden
aufgefordert, sich bei Interesse an der Aufnahme einer Arbeit in die Reihe mit den
Herausgebem in Verbindung zu setzen.

Eine Liste der bisher erschienenen Schriften ist am Ende dieser Arbeit und auf den
Web-Seiten der Herausgeber zu finden.
Prof. Dr. J. P. Krahnen Prof R. Stehle, Ph.D.
Johann Wolfgang Goethe Universitat Humboldt-Universitat zu Berlin
Fachbereich Wirtschaftswissenschaften WirtschaftswissenschaftlicheFakultat
Professur fiir Kreditwirtschaft und Finanzierung Institut fiir Bank-, Borsen- und
MertonstraBe 17-21 Versicherungswesen
D-60054 Frankfurt am Main Spandauer StraBe 1
Tel.: (069) 798-22568 D-10178 Berlin
Fax:(069)798-28951 Tel.: (030) 2093-5761
E-Mail: krahnen@[Link] Fax: (030) 2093-5666
[Link] E-Mail: stehle@[Link]
[Link]
Acknowledgments
It would have been impossible to undertake the present study without the support of
many helpful persons. First of all, I would like to thank Prof. Dr. Jan Pieter Krahnen
for directing the present thesis. He has provided me with a wealth of detailed,
thoughtful, and constructive conmients. I would also like to extend my thanks to Prof.
Dr. Dieter Nautz for taking it upon himself to write the second evaluation of my the-
sis, as well as to Prof. Dr. Uwe Walz and Prof. Dr. Mark Wahrenburg for their par-
ticipation in the examination-commission.

The team of the Institute for Capital Market Analysis at the Johann Wolfgang Goethe
University and the Center for Financial Studies in Frankfurt am Main made important
contributions to my work that helped assure the success of the present study. I would
like to extend special thanks to Dr. Ralf Elsas, who read earlier versions of parts of
this thesis and made me aware of some inconsistencies.

In addition, I am deeply grateful to Jesko Meyer, who not only offered me his friend-
ship, but also read the thesis with great care and made many helpful suggestions. My
thanks also go to Jesus Diaz, Freddy Moncayo, and Esteban Lx)mbeyda for their
econometric and IT-support. Marcus Brainard and Anne helped me with the correc-
tion of the language.

I greatly appreciate the support provided by the National Council of Science and
Technology (CONACYT) of the Mexican Government; without the financing from
CONACYT, my studies at the University of Frankfurt am Main would not have been
possible.

Finally, my greatest thanks is for my wife, Lorena Mondragon. Not only did she leave
her work and family in Mexico, but she has been a constant source of support and mo-
tivation, and has helped me in the preparation of the final version of this thesis.

Victor Silverio Posadas Hernandez

VII
Contents
1 Introduction 1
2 Latin American Emerging Markets 11
2.1 Introduction 11
2.2 The Latin American Emerging Markets under Study 13
2.3 Previous Investigations of LAEM 14
2.4 Risk Development in Latin American Emerging Countries 15
2.4.1 Political Risk 17
2.4.2 Economic Risk 19
2.4.3 Financial Risk 21
2.4.4 Composite Risk Index 22
2.5 Investment Law Index 25
2.5.1 Shareholder Rights and Law Enforcement 26
2.5.2 Insider Trading Index 28
2.5.3 Barriers to Foreign Equity Investment 31
2.5.4 Investment Law Index 34
2.6 Conclusions 36
3 An Index Methodology for Analyzing and Comparing the Development State
and Trading Architecture of Stock Markets 38
3.1 Introduction 38
3.2 Trading Costs across Latin American Stock Exchanges 40
3.3 Development Indicators of the LAEM 42
3.3.1 Stock Market Size 43
3.3.2 Liquidity 44
3.3.3 Stock Market Concentration 46
3.3.4 Number of Quoted Firms 50
3.3.5 Composite Index of Stock Market Development 51
3.3.6 Stock Trading Architecture 53
3.3.7 Stock Market Intermediaries 54
3.3.8 Trading Systems 58
3.3.9 Custody, Clearing, and Settlement Process 77
3.3.10 Trading Architecture Index 89
3.4 Conclusions 90
4 Univariate Portfolio Approach 94
4.1 Introduction 94
4.2 Empirical Evidence 96
4.2.1 Evidence from Developed Markets 97
4.2.2 Evidence of Emerging Markets 98
4.3 Database 100
4.4 Characteristics of the Analyzed Stock Markets 103
4.5 Return Characteristics 104
4.6 Methodology 110
4.6.1 Portfolio Approach 110
4.6.2 Preliminary Computations 110
4.7 Results 112

IX
 4.7.1 3-Portfolio Approach 112
4.7.2 6-Portfolio Approach 123
4.8 Conclusions 125
5 Regression Approach 129
5.1 Introduction 129
5.2 Methodology 131
5.2.1 Time Series Regression Approach 133
5.2.2 Cross-sectional Regression Approach 135
5.3 Results 136
5.3.1 Results of the Time Series Approach 137
5.3.2 Results of Cross-sectional Regressions 152
5.4 Conclusions 156
6 Conclusions 158
References 175
Appendixes 187
Appendix 1: Rating System of the ICRG 187
Appendix 2: DS-Index without Market Concentration 188
Appendix 3: Three-Factor Regression 189
List of Tables
Table 2.1: Composite Risk Index 25
Table 2.2: Shareholder Rights Index 26
Table 2.3: Law Enforcement Index 30
Table 2.4: Insider Trading Index 31
Table 2.4: Financial Liberalization Dates 33
Table 2.6: Investment Law Index 35
Table 3.1: Trading Costs 41
Table 3.2: Market Concentration 48
Table 3.3: Development State Index 52
Table 3.4: Market-Makers and Intermediary Index 57
Table 3.5: Trading Mechanisms 60
Table 3.6: Stock Orders 62
Table 3.7: Segments of the Stock Markets 63
Table 3.8. Trading Mechanism for Order Size 64
Table 3.9: Electronic Trading Systems 68
Table 3.10: Transparency of Stock Trading 72
Table 3.11: Use of Call Auctions 75
Table 3.12: TS-Index 76
Table 3.13: Central Securities Depositories-Registries Shareholders 79
Table 3.14: Central Securities Depositories-Registries 80
Table 3.15: Clearing and Settlement 83
Table 3.16: Settlement Assurance 87
Table 3.17: Custody, Clearing, and Settlement Index 88
Table 3.18. Trading Architecture Index 90
Table 3.19: DS- and TA-Indexes vs. Implicit Cost of Trading 93
Table 4.1: Summary Statistics for the LAEM 105
Table 4.2: Characteristics of the Market Monthly Retums 106
Table 4.3: Return Correlation between the Latin America IFCG Indexes 107
Table 4.4: IFCG Price Index Correlation 109
Table 4.5: Summary Statistics for Portfolios Sorted by Size 114
Table 4.6: Summary Statistics for Portfolios Sorted by P/BW 116
Table 4.7: Summary Statistics for Portfolios Sorted by P/E 117
Table 4.8: Summary Statistics for Portfolios Sorted by Turnover 118
Table 4.9: Summary Statistics for Different Periods 121
Table 4.10: Summary Statistics for Portfolios Sorted on a Monthly or Yearly Basis 124
Table 4.11: Summary Statistics for the 6-Portfolio Approach 126
Table 4.12: Summary Results of Chapter 4 128
Table 5.1: CAPM Regressions 139
Table 5.2: Correlation of the Portfolio Return Differences 142
Table 5.3: Two-Factor Regressions 144
Table 5.4: Summary of the Three-Factor Regressions 150
Table 5.5: Cross-Sectional CAPM 154
Table 5.6: Cross-sectional Regressions 155
Table 6.1: Summary Results of Implicit Trading Costs 165
Table 6.2: Summary Results 173

XI
List of Figures
Figure 2.1 Political Risk Index 18
Figure 2.2: Economic Risk Index 20
Figure 2.3: Financial Risk Index 22
Figure 2.4: Elements of the Composite Risk Index 23
Figure 2.5: Composite Risk Index 24
Figure 2.6: Stock Market Openness to Foreign Investments 34
Figure 2.7: Components of the Investment Law Index 35
Figure 3.1: Stock Market Size (MC/GDP) 44
Figure 3.2: Liquidity 45
Figure 3.3: Number of Quoted Firms 50
Figure 3.4: Components of the Development State Index 52
Figure 3.5: Components of the Trading Architecture Index 91
Figure 4. l:IFC-S&P-Indexes 101

XIII
Table of Abbreviations

B/M Book-to-Market
CAR Capital Adjusted Rate
CATS Computer Assisted Trading System
CCS-Index Custody, Clearing, and Settlement Index
CRI Composite Risk Index
CSDs Central Securities Depositories-Registries
DS-Index Development State Index
DvP Delivery versus Payment
E/P Eamings-to-Price
EMDB Emerging Market Database
ETS Electronic Trading System
FIBV Federation of Stock Exchanges
GDP Gross Domestic Product
ICAPM International CAPM
lAPT International APT
ICRG International Country Risk Guide
lEP Indicative Equilibrium Price
IFCG IPC Global Index
IFCI IPC Investable Index
IFC-S&P International Finance Corporation and Standard and
Poor's
IID Independently and Identically Distributed
I-Index Intermediary Index
LAEM Latin America Emerging Markets
MC Market Capitalization
MSWB Modified P of Scholes and Williams
NQF Number of Quoted Firms
0-Index Openness Index
OLS Ordinary Least Squares
P/BV Price-to-Book-Value
P/E Price-to-Eamings
S Stock Market Capitalization
TA-Index Trading Architecture Index
TO Turnover
TS-Index Trading System Index
VT/GDP Value of all Stocks Traded in a year

XV
1 Introduction
Interest in the Latin American emerging markets (LAEM) has increased considerably
in recent years. However, in their stock markets the price determination process and
how it compares with that of developed markets is still an open issue. Thus far, the
LAEM and most of the emerging markets may have, as it is often claimed, paid a
price for being too different, that is, for having weak institutions, failed macroeco-
nomic programs, political instability, poor corporate governance, and high trading
costs. Although they may have indeed suffered for these reasons, this claim ignores
the heterogeneity that exists among emerging markets regarding their market devel-
opment and institutional infrastructure (Yilmaz (2001)). Practitioners still think that
the LAEM may lower an international investor's unconditional portfolio risk. In view
of this belief concerning emerging markets, the present thesis seeks to answer three
sets of questions: (1) What are the investment laws in the LAEM and how do they
compare to developed countries? (2) How heterogeneous are the implicit trading costs
in the LAEM and which factors are responsible for the heterogeneity? And how dif-
ferent is the implicit trading cost of the LAEM from the developed stock markets?
And (3) does the predictability of stock returns in the LAEM differ from those docu-
mented for developed markets?

A large number of investigations in modem financial economics have been dedicated

to quantifying the trade-off between risk and expected returns of financial securities.
Financial economists and practitioners argue that this trade-off will depend on the de-
gree to which a security's return covaries with the consumption of a representative in-
vestor. However, the implementation of this explanation poses a problem because the
representative investor's consumption is not known with certainty. A solution to this
problem is offered by the Capital Asset Pricing Model (also called CAPM) developed
by Sharpe (1964), Lintner (1965), and Black et al. (1972). The CAPM makes two as-
sumptions: (1) the expected returns and the risk are linearly related and (2) the risk of
an investment is determined only by the covariance of its returns with the returns of
the portfolio of all assets in the economy, which is to say, ^ is sufficient to describe
the expected returns.

Since the CAPM was first developed, a large number of studies have examined
whether it explains the cross-section of realized average returns. Empirical investiga-
tions have shown that the CAPM is unable to explain the cross-sectional variation in
expected returns. For example, in their seminal paper Fama and French (1992) show
that stock risks are multidimensional, that is, stock market returns (R^ -Rj)ov P'm

combination with other variables (such as size, price-to-book-value, eamings-to-price,

and turnover, which are usually called market anomalies) better explain the cross-
sectional average returns.

Several theories seek to explain the contradictions of the CAPM. Four explanations
are most important: (1) Fama and French (1992, 1993) argue that anomalies must be
approximations of risk. (2) De Bondt and Thaler (1987) claim that investors set prices
irrationally. (3) Daniel and Titman (1997) argue that firm characteristics rather than
the covariance structure of returns appear to explain the cross-sectional variation in
average stock returns. And MacKinlay (1995) maintains that the strong relations be-
tween the anomalies and the average returns are the result of chance. Giving support
to any one of the theories is difficult, since there are enough facts that can be used ei-
ther to support or to reject them. However, as long as we cannot observe the mean-
variance efficient market portfolio, we can not confirm or reject the CAPM.

Four anomalies are among the most popular in the academic literature for developed
markets: (1) the firm size effect, which was first documented by Banz (1981). He
showed that stock market capitalization (5), together with J3, explains the cross-section
of average returns and that stocks with a small market capitalization have higher aver-
age returns than do large stocks. (2) The book-to-market (B/M) ratio reported by
Stattman (1980), who found that average returns on U.S. stocks are positive related to
the B/M ratio. (3) The eamings-to-price (E/P) ratio documented by Ball (1978), who
argued that the E/P helps to explain expected returns: stocks with higher risks and ex-
pected returns are likely to have a higher E/P, regardless of the unnamed sources of
risk. And (4) the turnover (TO) or liquidity. A decrease in liquidity may increase ex-
pected returns because the investors must be compensated for the higher transaction
costs they may face.^ Liquidity continues to gain in importance (Amihud and Mendel-
son (1986)).

' The size of a security is determined by the market capitalization of its common stock; B/M is the account-
ing value of the security to its market capitalization; accounting net profits reported by the firm to price per
share is the E/P ratio; and the TO is the ratio of shares traded of a security to its outstanding shares.
The joint role of anomalies has also been the subject of numerous papers. Ball (1983)
argues that the E/P ratio, together with size and P, explains the cross-sectional average
returns on U.S. stocks. Chan, Hamao, and Lakonishok (1991) found that of four vari-
ables considered, the B/M ratio and cash flow yield have the most significant positive
impact on expected returns on Japanese stocks.

For the U.S. stock markets, Fama and French (1992), using the cross-sectional ap-
proach of Fama and MacBeth (1973), have found that their test does not support the
predictions of the Sharpe, Lintner, and Black model. With data for only nonfinancial
firms from the CRSP and COMPUSTAT, they show that for the 1963-1990 period,
size and book-to-market capture the cross-sectional variation in average stock returns.
Fama and French (1993) expands the asset price tests of (1992) by using the time se-
ries regression approach of Black, Jensen, and Scholes (1972). Fama and French
(1993) corroborate that portfolios constructed to mimic risk factors related to size and
book to market capture the strong variation in returns and remains significant even
when other factors are included. They interpret this result as evidence that size and
book-to-market do indeed proxy for sensitivity to common risk factors in stock return.

In recent years fund managers have substantially increased their participation in

emerging stock markets, especially in Asia and Latin America. However, despite the
high equity flows to the emerging markets, researchers have only recently become in-
terested in these markets. As a consequence, the amount of research on them is still
limited. By contrast, a large number of investigations have been devoted to quantify-
ing the trade-off between risk and expected returns for developed markets.

Over the past years countries initially known as "less-developed countries" (such as
Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela) eventually became
"emerging markets." There are many reasons for this shift in designation. Despite the
recent episodes of financial turmoil in the countries just listed,^ their stock market
capitalization increased significantly over the past years as a result of the implementa-
tion of market-oriented policies, which promote private ownership, including owner-
ship by non-national investors. Furthermore, massive privatization programs, changes
in established corporate law, and the use of financial innovations, improvements in

Or thanks to them, because the interest on the sovereign debt of these nations diminished (Levich (2001)).
the regulatory framework, structural and technological changes of the stock markets
have characterized the LAEM of late.

Before beginning to test whether the CAPM explains the cross-section of realized av-
erage returns in the Latin American stock markets, it is first necessary to be conscious
of the specific features that differentiate the LAEM from developed markets. To better
understand the LAEM, in Chapters 2 and 3 we present and discuss their country risks,
investment laws, and stock trading infrastructure. In Chapter 2 we focus on two ques-
tions: (1) What are the financial, economic, and political conditions of the LAEM?
And (2) what are the investment laws there? To answer the first question, the political,
economic, financial, and compound risk indexes of the ICRG are used. In order to
evaluate the investment laws directly, information on investor regulation, shareholder
rights, their enforcement, insider trading, and barriers to foreign investors is aggre-
gated into an investment law index. This is contrary to La Porta et al. (1998), who
analyze shareholder rights, law enforcement, and insider trading separately.

Before an investor decides to participate in a stock market, he will compare it with

other markets. The literature often mentions three factors that are relevant for their
comparison: stock returns, their associated risk, and cost of trading. Chapter 3 concen-
trates on costs of trading in the LAEM.^ It is important to study the trading costs since
it can reduce the return on an investment, especially in illiquid markets. Furthermore,
the composition of a global portfolio can change when trading costs are taken into ac-
count (Domowitz et al. (2001)). Trading costs can be decomposed into explicit and
implicit costs. Due to the difficulties involved in quantifying them. Chapter 3 concen-
trates on implicit costs. According to the literature, especially two characteristics of a
stock market influence implicit costs: state of development and trading architecture.

By means of indexes, in Chapter 3 we answer three questions: (1) How heterogeneous

are the implicit trading costs in the LAEM? (2) Do trading costs of the LAEM differ
significantly from those of developed economies? And of considerable importance:
(3) Which factors are responsible for the differences? The chief aim of this chapter is
to answer these questions. To do so, two main indexes are constructed here: the De-
velopment State Index (DS-Index) and the Trading Architecture Index (TA-Index).
The design of indexes has proved to be an efficient way to make comparisons be-

^ Stock returns and its associated risk are the subjects of Chapters 4 and 5.
tween stock markets (DemirgUc-Kunt and Levine (1996), Erb, Harvey, and Viskanta
(1996)).

Chapters 2 and 3 are largely descriptive, their principal aim being to help the reader
gain an appreciation of the great heterogeneity that exists among the LAEM. This het-
erogeneity may imply that the risk factors underlying expected stock returns vary
among the LAEM and differ from those of developed markets.

Using the Emerging Market Database (EMDB) of the International Finance Corpora-
tion and Standard and Poor's (IFC-S&P), the stock return determinants in the LAEM
are investigated on an aggregate firm level in Chapters 4 and 5. The EMDB contains
data of series at stock, index, and market levels for emerging markets. A discussion of
the database is undertaken in Chapter 4.

In recent years some papers have analyzed the risk and returns in emerging markets.
The existing investigations were conducted on country or firm levels. On an aggregate
country level, portfolios consist of country indexes (stock markets indexes). The
country indexes are assigned to a portfolio according to country or stock market char-
acteristics. On the other hand, on an aggregate firm level, the return premiums are
studied by comparing the return on portfolios that are constructed by sorting stocks
according to observable firm characteristics.

Due to the properties of the LAEM, the analysis in Chapters 4 and 5 is conducted at
firm level and by means of a one-way grouping procedure. This approach is supported
by several studies. First, Harvey (1995) has shown that emerging market returns are
influenced by local rather than by global information variables. The influence of local
information might be due to the fact that emerging markets are segmented from world
capital markets. Bekaert (1995) has identified a significant number of barriers that
might effectively segment emerging markets from global capital markets. He has also
shown that emerging markets have a different degree of market integration. Further-
more, Bekaert and Harvey (1995) have found that some emerging markets have be-
come more segmented despite recent waves of liberalization."^ We use the one-way
grouping procedure since the number of stocks quoted on each LAEM is not enough
to carry out a two- or three-way grouping procedure. Furthermore, the EMDB does

In 4.5 it is shown that the return cross-country correlations of the IFCG indexes have increased but that
they are still small compared to developed markets.
not cover all stocks. For example, only twelve stocks on the Venezuelan stock ex-
change are included for one month. An alternative would be to combine the stocks of
each country in order to apply a two-way grouping procedure and calculate an Inter-
national CAPM or APT (ICAPM or IAPT, respectively). However, these models as-
sume integrated capital markets with no differences in the purchasing power parity,
legal and trading systems, etc. Thus, using an ICAPM or lAPT might be inappropriate
for the LAEM.

We pursue two goals in Chapter 4. The first is to investigate whether additional risk
factors explaining stock return variation in developed markets are also present in the
LAEM. In this chapter we concentrate on the predictability of average returns at an
aggregate stock level and test whether, as in the case of the developed markets, S and
the ratios price-to-book-value (P/BV), price-to-eamings (P/£), and TO, are related to
the stock returns on Latin American stocks. The selection of these variables is moti-
vated by the existing evidence on U.S. and other developed markets and by the prac-
tice of security analysts (see Chan, Hamao, and Lakonishok (1991)). Since 5, P/BV,
and P/E are all scaled by the price, we test whether TO is related to the return premi-
ums. We use TO because investors commonly monitor it in order to make an invest-
ment decision. Furthermore, TO is important for the firms, because less liquid stocks
may have to pay an extra premium as compensation.

The second objective of Chapter 4 is to reconcile or to find the causes for the contra-
dictory results concerning several anomalies documented in previous studies. Rou-
wenhorst (1999) found that return factors in emerging markets are similar to those
documented for many developed markets. In particular, all emerging market stocks
exhibit momentum and small stocks outperform large stocks, and value stocks outper-
form growth stocks. On the other hand, Claessens et al. (1995) show that there is a
size effect for some markets, but this effect is not necessarily related to the smallest
size stocks. Furthermore, they do an F-test for the equality of returns across all portfo-
lios in each market. They found that the difference between all portfolios is not sig-
nificant at the 5% level for any country. In summary, both papers show contradictory
results for the anomalies that they both analyze (size and value).^

^ Firms with high ratios of B/M, E/P, or cash-flow-to-price are classified as value stock (see Fama and
French (1998)).
The sources of the contradictions in their results are still unclear. However, there
might be four important reasons for the differences in results. (1) The analyzed sam-
ple period varies in both investigations. (2) Stocks are grouped in different number of
portfolios: while Rouwenhorst constructs three portfolios (top 30, middle 40, and bot-
tom 30%), Claessens et al. construct four portfolios (top 25%, top-middle 25%, bot-
tom-middle 25%, and bottom 25%). (3) Rouwenhorst sorts stocks monthly, while
Claessens et al. does so on a yearly basis. And (4) to compute portfolio returns, they
each weight stocks differently. Therefore, in this chapter we conduct a simple portfo-
lio approach by which stocks are sorted into one of three or six portfolios, the stock
allocation takes place each month or year, and the calculated returns are either equally
or value-weighted. Finally, with a r-test we check whether the returns of the top and
bottom portfolios are significantly different and compare results. Here we also present
the empirical evidence on developed and emerging stock markets, introduce the
EMDB, and discuss and document the stock return characteristics of the LAEM.

Although helpful, the portfolio (or univariate) approach taken in Chapter 4 cannot an-
swer questions such as: Would P be able to absorb the return variation if the funda-
mental variables were to become insignificant? Or if one of the fundamental variables
were to become significant while y^did not? Or if both of them were to explain the re-
turn variation? Or if a third factor may even be needed? To answer these questions, a
multivariate regression approach is conducted in Chapter 5. The use of a multivariate
analysis makes sense since 5, P/BV, and P/E are multiplied by the price. As a conse-
quence, some of the explanatory variables may prove to be redundant in the descrip-
tion of average returns. It is therefore necessary to clarify the relation between the fac-
tors and to find the combination that best explains the expected stock returns.

The next aim of Chapter 5 is very much in keeping with Chen and Kan (1989).^ In or-
der to verify the robustness of the results obtained by the econometric methodologies,
two different multivariate regression approaches are implemented: the time series re-
gression approach developed by Black et al. (1972) at a portfolio level and the cross-
sectional approach developed by Fama and MacBeth (1973) at a stock level. The time
series regression approach is used first. Monthly excess returns of each portfolio are

Davis et al. (1999) have also documented that the long-term return anomalies are sensitive to methodology.
regressed on market portfolio excess return (R^ ~ ^ / ) ^^^ ^n return differences in

portfolios that mimic S, P/BV, P/E, and TO.

For each stock market, different variants of the equation below are computed in order

to define the combination of factors that best captures the common variation of stock

returns:

R,, -Rf^ =c-^AKt - ^ / J + ' ^ V P S ) . + ^ ^ / ^ V P 3 ) . ^^Pl^in-n), ^ITO^FX-F,), +^P.'

where P = PI, P2, or PJ; r = 1, ... 163; Rpt is the return on portfolio P in month r; R/t

is the risk-free rate in r, and Rm,t is the return on the stock market portfolio in t and

S(pi.p3),t is the return difference between the sized portfolios PI and P3 in r, P/BV(Pi.

P3)j is the return difference of the P/BV portfolios PI and P3 in /, P/E(Pi.p3)j is the re-

turn difference of the P/E portfolios PI and P3 in r, and T0(PJ.P3)J is the return differ-

ence of the TO portfolios PI and P3 in t.

The time series approach has several advantages. (1) It offers a simple and formal re-
turn metric by which to choose the best combination of risk factors. (2) With the in-
tercepts it is possible to test how well the different combinations of the variables ex-
plain the average returns.^ (3) The high volatility of stock returns in these markets will
not lower the power of the asset pricing test. And (4) the number of stocks included in
the EMDB is sufficient in order to carry out the necessary calculations.

The cross-sectional approach is the second multivariate methodology used here. It is a

two-pass regression approach. First, the fi is estimated for each asset based on a time

series regression. Then, for each time period the market risk premium At must be es-

timated based on a regression across assets. This methodology has two advantages:

(1) it can aggregate additional risk measures beyond >^ and (2) >^and the coefficients

of the explanatory variables are updated periodically. Since we do not have enough

stocks to construct portfolios in each market and since analysis at a portfolio level

may generate biases in statistical inferences (Lo and MacKinlay (1990)), we evaluate

whether the market returns completely explain the realized stock returns without

^ See Fama and French (1993).

forming portfolios. The cross-sectional approach with one-factor (CAPM), two-factor,
and five-factor is only applied in the Brazilian and Mexican stock markets.^

Although helpful, the methodology developed by Fama and MacBeth (1973) also has
problems. One is the bias it generates against finding a systematic relation between P
and returns.^ The reason for this is that tests on the unconditional CAPM are based on
expected and not on realized returns (Pettengil et al. (1995)). If one tests the CAPM
with realized returns, one should also consider the segmented relation between real-
ized returns and P in order to avoid the bias against the systematic relation between P
and returns.

Since our results confirm the hypothesis of Pettengil et al. (1995), the conditional
CAPM is tested. Considering the conditional relation between P and realized returns.
Chapter 5 presents estimates of some combinations of Equation (5.15):

/?,,, -R,,, =c, +A,AA, +\,{\-D,)fi,^ +s,S„ +b,P/BV,^ +e,P/E,^ +l,TO,, +s, (5.15)

where/?,, -R^^is the excess return on stock /, Pit is the modified Scholes and Wil-
liams P, Dt is a dummy variable that takes on the value 1 if the market risk premium
in t is positive ({R^^ - R^^) > 0) and otherwise 0, and 5/,^ P/BVtt, P/Eit, and TOtt are
the market capitalization, price-to-book-value, price-to-eamings and turnover of stock
/ in t. Adding 5, P/BV, P/E, or TO to the conditional relation between returns and P
does not pose a problem. For the additional factors, it is not necessary to test for a
conditional relation since their values are always positive.

There are four main results of this thesis: (1) The ICRG indexes show that the Latin
American countries analyzed here are still riskier than the developed countries con-
sidered. However, the ICRG index has been improving faster in the LAEM than in the
developed countries. (2) The Investment Law Index in the LAEM is as heterogeneous
as in the developed countries (Chile has an IL-Index similar to those of the UK and
the U.S., while Brazil, Argentina, and Peru have IL-Indexes similar to those of
France, Germany, and Italy). (3) From the Development State Index and the Trading

The other markets are not included in the cross-sectional analysis due to the low number of stocks.
' Other complications with the cross-sectional methodology are the "error-in-variables," which is caused by
the use of estimated (from data) ^s, and the unobservability of the true market portfolio (see Roll and Ross
(1994)).
Architecture Index can be inferred that trading in Latin America is more expensive
than in the developed markets, although there are important differences among the
LAEM. (4) The empirical evidence from the developed markets presented by Fama
and French (1992 and 1993) regarding market anomalies is not corroborated in the
LAEM. The statistical significance of the firm-related variables depends on the coun-
try, period, frequency at which stocks are sorted (that is, monthly or yearly) and on
the way in which stocks are weighted (that is, equally or value-weighted).

10
2 Latin American Emerging Markets

2.1 Introduction
This chapter presents Latin American emerging markets. Here we shall discuss two
questions that are important to investors: (1) What are the financial, economic, and
political characteristics of Latin America? And (2) what are the investment laws
there? To answer the first question, the political, economic, financial, and compound
risk indexes of the International Country Risk Guide (ICRG) are used. As regards in-
vestor regulation, on the other hand, shareholder rights, their enforcement, insider
trading, and the barriers imposed on foreign investors are first discussed. Thus, to an-
swer the second question, it is necessary to construct an Investment Law Index by
which the relevant information is aggregated.

In the literature it is often said that finance, economic, and political conditions are
very important aspects of a stock market since they influence the stock returns and
fundamental variables of firms (Erb et al. (1996)). Furthermore, a discussion of these
activities is also relevant due to the transformation process in which Latin American
countries became involved.

To describe each stock market and compare it with the other markets, a direct evalua-
tion of their financial, economic, and political conditions is carried out. The direct
evaluation consists in discussing four country risk indexes that have been computed
by the ICRG: political, economic, and financial risk indexes, as well as the com-
pounded or total risk index. The ICRG's risk indexes are well regarded by researchers
because they include relevant factors for investors and are correlated with ratings of
Standard & Poor's, Moody's, and Institutional Investors.

Theoretical and empirical studies show that the analysis of market regulation and en-
forcement is important since both can generate frictions that negatively affects statis-
tical properties of stock returns: If frictions were to exist, agents would not possess
symmetric information and prices would not reflect expected values. These might
cause prices not to follow processes such as random walk or other forms of martin-
gale. For this reason, in this chapter we discuss laws that incentive investments, that
is, laws designed to avoid frictions. Shareholder rights, law enforcement, insider trad-
ing, and investment barriers are discussed in this chapter, since they are among the
most studied market characteristics in the literature that might cause non-trivial fric-
tions.^^

The literature on the effects of regulation on stock returns is abundant. La Porta et al.
(1998) found that premia on securities in 49 developed and emerging countries de-
pend on the ownership rights and on the legal capacity to enforce these rights, as well
as on how well rights are protected. Other researchers point out how insider trading
and barriers to foreign investments influence features of stock returns (for instance,
Stulz (1981), Meulbroek (1992), Bailey and Jagtiani (1994), Hart (1995), Stulz and
Wasserfallen (1995), Domowitz et al. (1997), Bhattacharya and Daouk (2002), and
Lombardo and Pagano (2000 and 2002)). In the second part of this chapter, the exis-
tence and enforcement of laws is first discussed. Then insider trading and barriers im-
posed on foreign investors are analyzed. Finally, contrary to La Porta et al. (1998), the
discussed variables are aggregated in order to compute an IL-Index. The development
of such an index has the advantage that it makes it easier to interpret information and
to compare information across stock markets.

The discussion of risk sources, shareholder rights, law enforcement, insider trading,
and investment barriers is of considerable importance not only for investors but also
for regulators. Investors may get a better understanding of stock returns since the fi-
nancial, economic, and political conditions directly influence the global mean-
variance efficient portfolios. Furthermore, laws and their enforcement also affect in-
ternational investors' returns. For example, due to barriers imposed on them, investors
will not get all the gains from international diversification that they would get were
those barriers not in place. On the other hand, differences in the investment regulation
will give policy makers a clearer understanding of the types of issues they need to ad-
dress.

The present chapter comprises five sections. In the first and second sections, the stock
markets under consideration are defined and results of previous studies are presented,
some of which prove to be contradictory. The third section contains a discussion of
the political, economic, and financial risk characteristics, followed by an analysis of

'° Governments could also pursue appropriate policies in order to the improve regulatory framework of
capital markets and bring domestic accounting and supervision standards into line with international
standards, actions that eventually boost public confidence in the domestic market (see Pohl et al.
(1995)).

12
the total risk index, which compounds the indexes of poUtical, economic, and finan-
cial risk. Section 2.5 compares the analyzed markets regarding their respective in-
vestment laws and their enforcement, insider trading, and restrictions on foreign in-
vestments. To do so, an index is designed. And in the final section, conclusions are
drawn.

2.2 The Latin American Emerging Markets under Study

To begin with, it is important to define the term "emerging market." The International
Finance Corporation defines an "emerging market" as a stock market in transition, in-
creasing in size, activity, or level of sophistication. Stock markets that retain or intro-
duce investment restrictions—such as foreign limits, capital controls, extensive gov-
ernment involvement with listed companies, and other legislative restraints on market
activity (particularly on foreign investors)—are usually considered to be emerging
markets. In general, the IFC classifies a stock market as "emerging" if it meets at least
one of two general criteria:

1. The market is located in a low- or middle-income economy as defined by the

World Bank. (According to 1997 data, these are economies with a GNP per
capita lower than US$ 9,656.)

2. The investiable market capitalization is low in comparison with its most recent
GDP figures.

According to this definition, all Latin American stock markets are regarded as emerg-
ing markets. However, a great heterogeneity exists among these markets. Areas such
as operational efficiency, quality of market regulation, supervision and enforcement,
corporate governance practices, minority shareholder rights, transparency, level of ac-
counting standards, and information levels, vary substantially among these stock mar-
kets (see Section 2.5, below).

While it would have been very interesting to analyze all the Latin American stock
markets, unfortunately the requisite information is readily available only for the re-
gion's largest stock markets. The stock markets analyzed here are Buenos Aires (Ar-
gentina), Sao Paulo (Brazil), Santiago (Chile), Bogota (Colombia), Mexico, Lima

13
(Peru), and Caracas (Venezuela). Hereinafter, these markets are referred to as
LAEM.^^

The IPC also mentions Ecuador, Jamaica, and Trinidad as "frontier markets." These
three markets are not treated in this study because they tend to be relatively small and
illiquid even by the criteria established for emerging markets. In addition, information
about them is typically less available than for the main emerging markets in Latin
America. According to the IPC, these markets do not even have the breadth (e.g., list-
ings), the depth (e.g., market capitalization and turnover), and infrastructure (e.g.,
regulatory structure, custody, clearance, and settlement) that would be required in or-
der to calculate indexes for them.

2.3 Previous Investigations of LAEM

Results of previous investigations of LAEM are contradictory. On the one hand, it is
said that in recent years countries initially regarded as "less-developed countries" -
such as Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela - became
"emerging markets" (see, e.g., Korajczyk (1996), Bekaert (1995), Bekaert and Harvey
(1995)). There are many reasons for this shift in classification. Despite the recent epi-
sodes of financial turmoil in these countries,^^ stock market capitalization increased
significantly over the last years as a result of their market-oriented policies, which
promote private ownership, including ownership by non-national investors.

The market capitalization of the largest Latin American markets, such as Brazil
(US$ 186.2 billion) and Mexico (US$ 126.3 bilUon), is larger than in several devel-
oped markets, such as Austria (US$ 25.2 billion) and New Zealand (US$ 17.74 bil-
lion). ^^ The total market capitalization of LAEM was US$ 434.4 billion at the end of
June 1992. From June 1992 to June 1999 it grew 65.7%. As the importance of equity
flows increased, the LAEM have become more integrated in the developed markets. ^"^

^* These stock markets are the most studied of Latin American markets (see, e.g., La Porta et al. (1997,
1998, 1999, and 2000), Domowitz et al. (1997), Henry (2000), Rouwenhorst (1999), and Fama and
French (1998)).
'^ Or thanks to the turmoil, because the interest on the sovereign debt of these nations diminished
(Levich (2001)).
'^ Market capitalization of shares of domestic companies excluding investment funds, rights, warrants,
convertibles, foreign companies, and including common and preferred shares and shares without voting
rights.
^^ In particular, private capital flows increased and a shift occurred in private flows from bank to non-
bank sources to portfolio and direct investment (see Claessens (1995)). The increase in order flow to
Latin America has been in the form of ADRs, GDRs, funds, and a small amount of derivatives. Several

14
Furthermore, the LAEM were characterized by massive privatization programs,
changes in established corporate law, and financial innovations, improvements in the
regulatory framework, and structural and technological changes in the stock markets.

The other point of view in the literature from the 1980s and '90s argues that Latin
American and all other emerging markets pay a price for being "too different," that is,
for having political instability, failed macroeconomic programs, small financial depth,
low liquidity, high stock market concentration, a small number of quoted firms, weak
institutions, and law enforcement problems (Levich (2001)). This framework either is
a disincentive for investors to participate in Latin American stock markets or results in
investors demanding higher premiums. As a result of these problems, the weight of
the LAEM on the total market capitalization of the IFCG composite index diminished
from 35% in 1992 to 22% at the end of 1999.

In fact, interest in the LAEM has increased in recent years. Relative to their econo-
mies, Latin American stock markets are large in comparison with other emerging
markets, such as Poland (19.9% of GDP) or Indonesia (17.5% of GDP), although still
small (37% of GDP) compared to developed markets. Furthermore, the market capi-
talization of Latin American stock markets at the end of 2001 was smaller compared
to some developed markets, such as in the United States (US$ 13.8 trillion),^^ Japan
(US$ 2.3 trillion), the United Kingdom (US$ 2.16 trillion), and Germany (US$ 1.1
trilUon).^^

2.4 Risk Development in Latin American Emerging Countries

The literature frequently mentions that the financial, economic, and political condi-
tions are very important for investors since those conditions also influence the risk as-
sociated with stock returns. The analysis of these conditions is also relevant in view of
the transformation process of Latin American economies. To assess the impact of the
reforms that have been implemented during this process, the outcome of such reforms
are evaluated next.

factors have been important in the increase in the capital flows to the LAEM. The decline in interna-
tional interest rates (Calvo, Leiderman, and Reinhart (1993)) and improved domestic policies give rise
to higher growth rates (Chuhan et al. (1993)) and market liberalization (Claessens and Rhee (1994)).
'^ This figure represents the sum of Amex, Nasdaq, and NYSE.
^^ Only Frankfurt is included.

15
The ICRG's political, economic, and financial risk indexes are used here to describe
the status of the Latin American countries. ^^ There are three reasons for using the
ICRG risk indexes. First, they are well regarded among researchers (see Erb, Harvey,
and Viskanta (1996)). Second, they include factors relevant to investors. Surveys by
Institutional Investors^^ show that the most relevant factors for investing in a country
are: economic outlook, debt service, financial reserves-to-current account, fiscal pol-
icy, political outlook, access to capital markets, trade balance, portfolio investments
inflow, and foreign direct investments. Using these and additional information, the
ICRG computes their risk indexes. The ICRG computes their political, economic, and
financial risk indexes using twelve political, five economic, and five financial factors.
Appendix 1 lists the factors and their weights. ^^ The last reason for using the ICRG
risk indexes is their high correlation with ratings of Standard & Poor's, Moody's, and
Institutional Investors (see Erb, Harvey, and Viskanta (1996)).

The ICRG's rating system consists of assigning numerical values to each risk factor.
The values are specified within a range that reflects the weight of the risk factor. To
determine the value of an index, the values assigned to each risk factor are summed.
The minimum number of points that can be assigned to a risk factor is zero, while the
maximum number of points depends on the fixed weight that the factor is assigned
from the overall risk assessment (for the maximum points assigned to each factor see
Appendix 1).^^ The scale is designed to indicate the highest value with respect to the
lowest risk and the lowest value with respect to the highest risk. This applies to all
countries. The risk points of the political index components are also assigned each
month by the editor for the region in which the country falls, on the basis of the ques-
tionnaire for each risk component. On the other side, the risk points for the economic

'^ The ICRG is a private provider of risk ratings that have proved to be reliable. The ICRG's risk rat-
ings have been cited by important publications, such as LaPorta et al. (1997) and Erb et al. (1996), as
well as in documents published by the International Monetary Fund and World Bank, among other in-
ternational institutions. Country reports of the ICRG include descriptive assessments and economic
data. The ICRG provides ratings for 140 countries on a monthly basis.
^* Institutional Investors is a provider of country risk ratings. The risk measures of Institutional Inves-
tors are based on a survey applied to leading international bankers who are asked to rate each country.
According to the information of Institutional Investors, to compute the ratings, respondents with greater
exposure and more sophisticated country analysis get greater weights. To identify the factors to be con-
sidered, survey participants are asked to rank the factors that they consider in preparing country ratings.
Two important facts should be considered: (1) bankers rank factors differently for different group of
countries and (2) their rankings have changed over time. Erb et al. (1996) provides a detailed descrip-
tion of the way in which Institutional Investors compute its ratings.
'^ A full description of each factor can be found at [Link]/[Link].
^ Also, the Guide to the ICRG Rating System explains in detail what the rating process is.

16
and financial risk components are automatically assigned each month on the basis of
the estimated ratios for the components.^^

The remainder of the present section is divided into four parts. In the first, political
risk is analyzed. Economic risk is discussed in the second part, while financial risk is
treated in the third. Finally, the CR-Index is discussed and compared across countries.

2.4.1 Political Risk

The importance that investors give to the political, economic, and finance risk indexes
depends on the market in question. For developed markets, Chan, Chui, and Kwok
(1999) argue that there is a sharp contrast between the nature of political and eco-
nomic news. Economic news impacts directly on the economy and thus on the stock
market. The impact of political news is less clear because: (1) it is not directly related
to economic activities, (2) politicians usually obfuscate the informational content of
the news, and (3) most of the analysts are well trained in economics and finance,
while they are less confident when it comes to analyzing political news. Therefore,
economic news has a greater impact on the stock market than does political news.^^
According to the ICRG, the evidence shows the reverse in emerging markets; the
ICRG considers political risk to be twice as important as economic and financial risk.
Furthermore, to participate in an emerging market, investors have to take different
factors into account than they do in a developed market or, in the most optimistic
case, the factors are the same but their weights are different (Erb, Harvey, and Vis-
kanta (1996)). Political risk is so important for the ICRG because it reflects a coun-
try's willingness to pay its debts while economic and financial risk is associated with
the ability to pay.

The political difficulties that have arisen in Latin America over the past two decades
give support to the ICRG. Most of the countries were transformed from dictatorships
into civil governments. In this process, elections used to be violent and fraudulent.
Elected governments lacked control over their congress; hence, officials had difficul-
ties in passing bills aimed at instituting structural reforms. Furthermore, there were al-
legations of corruption in the privatization and sale of the various state-owned com-
panies, from which politicians and their families presumably profited illegally. In ad-

^^ The available information for the political risk scores is subjectively evaluated by the staff, while the
financial and economic risk assessments are made solely on the basis of objective information.

17
dition, the increasing role of drug and guerrilla organizations gave rise to serious po-
litical uncertainty. However, there is a heterogeneity among the Latin American coun-
tries, and these events have been felt differently in the political and economic land-
scape of each country (see Figure 2.1).

Figure 2.1 depicts the political risk indexes of the ICRG. Over the period analyzed,
the behavior of the political index differs among the LAEM. While the political index
increased by 71% in Chile and 59% in Peru, it decreased by 25% and 10% in Vene-
zuela and Colombia, respectively. Compared to the other LAEM, the political risk in-
dexes were stable in Brazil and Mexico and belong to the highest over the whole pe-
riod analyzed. Figure 2.1 also shows the decreases in the index in most of the LAEM
from 1995 to 1999 as a consequence of the crises in Mexico and Brazil.

ILvy^
M Ly

Arg Bra Chi Col Peru Ven Fra Ger UK USA

Figure 2.1 Political Risk Index

The Political Risk Index of the ICRG is shown for the time period January 1986 to July 2002. The Po-
litical Risk Index scores range from 0 to 100. Zero points mean a very high risk and 100 points indicate
the lowest potential risk. The Political Risk Rating includes 12 weighted variables covering both po-
litical and social attributes (see Appendix 1).

Compared to developed countries, the political risk ratings of the LAEM are signifi-
cantly lower, which is to say, the political instability in the LAEM is higher. How-
ever, Chile, Mexico, and Peru showed greater improvements than France, Germany,
the UK, and the U.S. From 1986 to 2002 the political risk rating of the U.S. dropped
by 9%, while it increased in Germany by 3%, in France by 3.2%, and in the UK by

^^ That is, the relation between the quality of information and market activity (Blume et al. (1994)).

18
8%. Interestingly, one can see in Figure 2.4 that when the U.S.-index diminished
(from 1989 to 1993), the indexes of most of the other countries also diminished. The
converse does not hold, however. For example, the political events in Mexico during
1994 which impacted on the whole of Latin America apparently did not influence ei-
ther the U.S. or Germany.

2.4.2 Economic Risk

In this section the focus is on macroeconomic factors, sunmiarized by risk ratings.

The economic risk rating aims to show the economic strengths and weaknesses of
Latin American countries. To assess economic development, the ICRG uses five risk
components: current account to GDP, real GDP growth, inflation, budget balance to
GDP, and per capita GDP.

The relationship between stock returns and economic variables has been widely dis-
cussed for developed markets. Balvers, Cosimano, and McDonald (1990) derived a
model in which stock returns are a function of macroeconomic conditions. Fama
(1990) shows for U.S.-stocks that substantial proportions of the variances in stock re-
turns can be attributed to economic variables such as real economic growth, industrial
production, and investment. For the UK, Lovatt (1996) explores the relationship be-
tween annual real total return on the FTSE All Share and the dividend yield, the in-
verted yield curve, the expected growth of real GDP, and the expected rate of con-
sumer price inflation.

Before we begin to analyze the economic risk index, it is important to review briefly
the economic events in Latin America since 1970 in order to gain a better understand-
ing of the current state of its economies. New factors came into play by the early
1970s (Lewis (1995)): Financial and commodity markets were more volatile,^^ world
trade grew at rates never before seen, international capital markets allocated resources
in the form of bonds to Latin America in order to finance government dissavings and
dubious projects. In contrast to some Asian countries, which oriented capital inflows
to export industries, to increase international competitiveness, and to build human
capital, Latin America invested in welfare projects and import substitution industries.
By the early 1980s, Mexico was in the throes of a debt crisis as a result of these poli-

^^ The breakdown of the Bretton Wood system caused inflation and increases in interest rates. On the
other hand, the prices of commodities fell. Especially in 1974 the price of oil dropped drastically.

19
cies, although it was triggered by Mexico's announcement of a moratorium. After
Mexico most Latin American countries fell into similar debt crises. The region en-
tered into a period that came to be known as the "Lost Decade of the 1980s." The
subcontinent began to change considerably: export-oriented industries were promoted;
the market economy replaced heavy government intervention and import substitution;
and governments tried to become smaller. Liberalization programs played a role in in-
creasing the GDP growth rates and reducing inflation. All these factors, including the
capital market reforms, help to explain to some extent the increase in private savings
by local and foreign investors, which in turn influenced the stock market activity. Al-
though the recent crises in Mexico and Brazil were actually brief and their effects on
the region's other economies were not as severe as previously, economic risk in the
region remains high (see Figure 2.2).

Figure 2.2: Economic Risk Index

The Economic Risk Index of the ICRG is shown for the time period January 1986 to July 2002. The
Economic Risk Index scores ranges from 0 to 50. Zero points mean a very high risk and 50 points indi-
cate the lowest potential risk. The Economic Risk Rating comprises 5 weighted variables (see Appen-
dix 1).

The trajectories of economic and political risk ratings show some similarities (com-
pare Figures 2.1 and 2.2). Chile, Peru, and Mexico have the lowest economic risk in
the region. First, economic risk diminishes over the period for most of the LAEM.
Second, the decrease in risk is most evident from 1990 to 1994; thereafter, the risk rat-
ings diminished (i.e. risk increased) as a consequence of the crises in Mexico and
Brazil. Third, Chile and Brazil registered the highest increases in economic risk, while

20
in Venezuela it decreased. And fourth, compared to developed markets, the LAEM
have significantly lower economic risk ratings, much greater volatility, and show
faster improvements.

2.4.3 Financial Risk

The Financial Risk Rating of the ICRG aims to provide a measure of the countries'
ability to pay. The financial risk rating includes measures related to a country's ability
to finance its official, commercial, and trade debt obligations (see Appendix 1 for the
financial risk components and their weights).^"^

Latin America's history of debt management has been highly dependent on business
cycles (Mexico 1995, Brazil and Colombia 1999, and Argentina 2002).^^ During a
debt crisis, governments and international finance institutions develop emergency
economic programs that specify objectives to be reached. In most cases, fiscal deficits
should diminish when several tax reforms are adopted. Once the economy begins to
recover, the country returns to the international capital markets. As a consequence, the
composition of external debt usually changes dramatically. The debt profile is recon-
figured and the maturity of debt is extended. In the best case, the external debt dimin-
ishes slightly (as in Mexico in 1998). Due to both the timely servicing of their interna-
tional debt obligations and their lower debt burden, countries earned upgrades in their
credit ratings (Argentina and Colombia 1996, Brazil and Mexico 2001). After a period
of growth with stability, governments begin to relax spending, which increases the
fiscal deficit and public sector debt. Financing the larger deficits pushes interest rates
higher, with contractionary effects on the private sector.^^ The increasing uncertainty
results in capital outflows, leaving the domestic savings and reserves insufficient to
meet their term financing needs. Furthermore, the debt ratings are downgraded and
the spreads get significantly wider. The difficulties in accessing international capital
markets obligates governments and international financial institutions to develop new
adjustment programs (Mexico 1995, Brazil 1998, Colombia 1999, and Argentina

^^ A complete description of the financial risk factors and the way in which the ICRG assigns risk
points to each component can be found at [Link].
^ During the period, Chile is the exception. Its foreign debt no longer constitutes a major structural
problem. As of November 1999, Chile's public and private foreign debt represented 43% of GDP,
while in 1985 it was 125%. Public-sector debt has remained low for the past years; it reached 7.4 % of
GDP in 1999, reflecting ten years without fiscal deficits. In 1995 the government and the Central Bank
prepaid over US$ 1.5 billion in debt to the International Monetary Fund.

21
2001). Hence the time at which one invests in the Latin American emerging countries
might well be extremely important.

Figure 2.3: Financial Risk Index

The Financial Risk Index of the ICRG is shown for the time period January 1986 to July 2002. The Fi-
nancial Risk Index scores range from 0 to 50. Zero points mean a very high risk and 50 points indicate
the lowest potential risk. The Financial Risk Rating comprises 5 weighted variables (see Appendix 1).

The financial risk indexes of the ICRG are presented in Figure 2.3. Similar to the po-
litical and economic indexes, during the analyzed period most of the LAEM showed
an increase in the risk rating, which was most evident from 1986 to 1993. Peru and
Mexico registered the highest improvements; Colombia and Venezuela, the lowest. In
1994 and 1995 all of the LAEM reverted to a high risk as a consequence of the crises
in Mexico and Brazil. Compared to France, Germany, the UK, and the U.S., the
LAEM have lower financial risk indexes. The latter indexes increased also at higher
rates than in the four developed countries^^ during the whole period.

2.4.4 Composite Risk Index

Two questions are of concern in this section: (1) How risky are the LAEM compared
to the most developed stock markets? (2) How different is risk among the LAEM? In
order to combine the results of the risk indexes and to answer these questions, the
composite risk index (CRI) calculated by the ICRG is used. The CRI-computation is a

^^ Additional domestic and foreign factors, such as political uncertainty, violence, or events in other
emerging countries, reinforce the uncertainty.
^^ In the U.S. the financial risk rating dropped from 49 to 35 points, and in Germany from 50 to 40
points.

22
sum of political, financial, and economic risk indexes. The political risk rating con-
tributes 50% and the financial and economic risk ratings each contribute 25%.

Risk Index (ICRG)

Polical Risk Index Economic Risk Index | Financial Risk Index

Figure 2.4: Elements of the Composite Risk Index

The Composite Risk Index is calculated by adding the Political, Economic and Financial Risk Indexes.
The political risk rating contributes 50% and the financial and economic risk ratings each contribute
25%.

The CRI is calculated by the ICRG with Formula 2.1:

CRL = 0.5 * P/? + 0.25 *ER-\- 0.25 * FR (2.1)

where CRIi is the composite risk index of country /, PR is the political risk index, FR
is the financial risk index, and ER is the economic risk index. The highest rating (100
points) indicates the lowest risk, and the lowest rating (0 points) indicates the highest
risk. The index is discussed for all the LAEM and two developed markets.

Table 2.1 reports the mean, standard deviation, growth rates, and average correlation
of the CRI of each country for the whole sample and two subperiods. The correlation
among the risk indexes for the whole sample period is also shown in Table 2.1. To
compute the average correlation, the correlation of country / with each other is first
computed and then averaged. The mean of the correlation of this country with the de-
veloped and Latin American markets is also calculated.

The results of Figure 2.5 and Table 2.1 clearly show that the LAEM are riskier than
the four analyzed developed countries and that the LAEM are heterogeneous. Com-
pared to the four developed markets, the CRI of the LAEM have much lower means
(riskier) and higher standard deviations over the whole period and also over the two
subperiods. However, the CRI in all LAEM, except Venezuela, grew at higher rates
than in Germany and the U.S. The LAEM are heterogeneous and can be divided into
two groups. The first group consists of the less risky countries: Chile and Mexico. The

23
country with the lowest CRI, thus the riskiest one, is Argentina followed by Vene-
zuela, Peru, Colombia, and Brazil. From the LAEM Chile and Peru had the highest
growth rates, while Venezuela had the lowest (its CRI decreased by 13% in the whole
period). These results do not change significantly from one subperiod to another. Also
interesting, the correlation between the risk indexes is not as high as one might have
expected. However, the correlation between the compound and political risk indexes
is the highest in most of the countries. This was expected because the political risk
index makes up 50% of the CRI. Furthermore, the correlation between the risk in-
dexes is usually lower in the Latin American countries than in the developed coun-
tries.^^ Finally, the CRI-correlation between the LAEM is low but higher than the U.S.
or Germany. However, the correlation among the LAEM and with the developed
markets tends to increase from the first to the second period.

90

ao
^
-Vx^
^ ^ v*
70
k
eo
f
1
1^
50

40

30

20 V
f][/ v^/ /
\A/^
/
10 y
AB Bra ON Od Max Per v^ Fra Ger UK USJV

Figure 2.5: Composite Risk Index

The Composite Risk Index of the ICRG is shown for the time period January 1986 to July 2002. Zero
points mean a very high risk and 100 points indicate the lowest potential risk

The reasons for this result would be worth analyzing in future research.

24
Table 2.1: Composite Risk Index

Arg Bra Chi Col Mex Per Van Fran Ger U.K. U.S. Jap

a^ Mean of the Composite Risk Index

1986-2002 31,55 33,52 48,69 41,03 41,51 22,81 35,37 88,06 92,18 87,85 90,92 91,44
1986-1994 24,96 29,18 37,56 38,14 36,17 13,82 36,42 86,13 92,06 86,23 90,33 93,51
1995-2002 39,45 38,73 62,04 44,50 47,91 33,59 34,12 90,38 92,32 89,79 91,61 88,96

b) Standard Deviation of the Composite Risk Index

1986-2002 9,04 5,62 14,64 4,31 8,78 10,73 2,52 2,84 1,64 2,37 2,14 3,12
1986-1994 5,66 2,75 10,39 2,90 7,03 2,64 2,45 1,72 1,93 1,33 2,69 1,96
1995-2002 5,04 3,13 2,99 2,93 5,97 5,14 2,04 2,06 J,24,_. 1:.81 0,83 2,36

c) Growth Rates of the Composite Risk Index

1986-2002 4,85 26,02 160,16 2,60 57,14 133,33 -13,35 12,94 -0,11 5,64 -3,95 -10,05
1986-1994 64,32 -5,02 123,17 15,63 26,65 32,08 -9,32 7,13 -4,56 -1,69 -5,71 -4,71

1995-2002 -38,82 20,36 15,11 13,79 21,96 56,54 3,93 4,94 3,86 6,84 2,32 -6,53

d) Country Correlation of the Composite Risk Index

Average Correlation
1986-2002 0,368 0,453 0,304 0,31 0,287 0,439 -0,146 0,349 0,089 0,379 0,277 -0,48
1986-1994 0,241 0,282 -0,116 0,304 -0,027 0,321 0,123 -0,124 -0,046 0,133 0,257 -0,061

1994-2002 0,019 0,395 0,429 0,334 0,282 0,42 0,407 0,355 0,387 0,213 0,325 -0,413

Average Correlation to Developed Countries

1986-2002 -0,025 0,2929 -0,156 0,002 -0,132 0,1304 -0,093 -0,065 0,44 0,162 0,430 -0,169

1986-1994 -0,304 0,6213 -0,762 0,094 -0,693 -0,098 -0,286 -0,7 0,809 0,750 0,736 0,80

1994-2002 -0,125 0,341

Averagie Correlation to Latin American Countries

1986-2002 0,631 0,559 0,611 0,518 0,566 0,645 -0,181 0,585 -0,062 0,472 0,211 -0,613
1986-1994 0,604 0,056 0,314 0,569 0,417 0,600 0,396 0,207 -0,413 -0,132 0,052 -0,43
1994-2002 0,115 0,432 0,464 -0,359 0,242 0,461 0,464 0,363 0,462 0,224 0,351 -0,284
The Composite Risk Index is from the ICRG. The composite scores ranges from 0 to 100. Zero points
mean a very high risk and 100 points indicate the lowest potential risk. The CRI comprises the Politi-
cal, Economic, and Financial Risk Index. In Panel C, the Growth Rates are indicated in percentage. In
Panel D, for the average correlation, the correlation of country i with each other is first calculated and
then the correlations are averaged.

2.5 Investment Law Index

In the literature much discussion has been devoted to how shareholder rights, law en-
forcement, insider trading, and restrictions on foreign investments affects the defining
features of stocks (e.g., Stulz (1981), Meulbroek (1992), Bailey and Jagtiani (1994),
Hart (1995), Stulz and Wasserf'allen (1995), Domowitz et al. (1997), La Porta et al.

25
(1998), Bhattacharya and Daouk (2002), and Lombardo and Pagano (2000 and
2002)). In particular. La Porta et al. (1998) discussed shareholder rights, law enforce-
ment, and insider trading differently for 49 countries. Such an analysis, although help-
ful, is nevertheless difficult for an investor to interpret. For this reason, we aim to de-
velop an index that aggregates information about the existing shareholder rights, law
enforcement, insider trading, and barriers to foreign investors and that is easy to inter-
pret and to compare across stock markets. Such an index should correctly reflect how
differently investors are protected around the world and the extent to which they can
invest in a foreign stock market.

Due to the difficulty of getting information, the Investment Law Index (IL-Index) is
computed only for the LAEM and five developed countries. In these countries we
want to determine the differences regarding (1) shareholder rights, (2) law enforce-
ment, (3) insider trading, and (4) investment barriers to foreigners across the LAEM,
and how they compare to some developed markets. In what follows shareholder rights
and enforcement of laws are first discussed and then insider trading and barriers im-
posed on foreign investors are analyzed. In the final section the collected information
is grouped in order to compute the IL-Index.

2.5.1 Shareholder Rights and Law Enforcement

Recent finance research shows that shareholder rights and the quality of law enforce-
ment also affect the defining features of stocks (Hart (1995)). The purchase of stocks
gives investors the right to receive dividends, but also to elect their company's man-
agers. The latter right is important because investors can vote against company direc-
tors. For this reason, laws aimed at establishing this right would enable investors to
get paid and firms to receive external finance.

This section examines how shareholder rights and law enforcement vary across the
LAEM and across some developed markets. Based on the results of La Porta et al.
(1998), two indexes are computed: a Shareholder Index (SH-Index) and a Law En-
forcement Index (LE-Index). The SH-Index includes eight variables of Table 2 from
La Porta et al. (1998).^^ To each variable, a value of 1 or 0 is assigned (explanation is
given in the lower part of Table 2.2 for the conditions under which a variable receives

^^ They consider that these eight variables represent the voting rights attached to shares, rights that pro-
tect the voting mechanism against interference from the insiders, and remedial rights.

26
1 and or 0). Then, averaging the values of the variables, the SH-Index is computed for
each stock market. The only difference between the SH-Index and the Antidirector-
Rights Index of La Porta et al. (1998) is that the SH-Index includes mandatory divi-
dends and the percentage of capital to call an extraordinary shareholder meeting. ^^
These variables are considered since both represent a right for a shareholders and not
a restriction. Furthermore, mandatory dividends are more important in countries with
a weak shareholder protection (La Porta et al (1998)).^^

In Table 2.2 the notorious differences of SH-Indexes among the LAEM can be ob-
served. Chile, Argentina, and Peru offer the strongest legal protection to investors,
while Mexico and Venezuela provide comparatively weak legal protection. Brazil and
Colombia fall in the middle. More surprising is that the evidence for developed mar-
kets is largely similar. The UK and the U.S. are located on the top, while Germany
and Italy offer the weakest legal protection. Compared to developed countries, Chile
has a SH-Index as high as the U.S.'s and the UK's, while Mexico's and Venezuela's
are as low as Germany's and Italy's. These results are slightly different from the out-
comes of the Antidirector-Rights Index of La Porta et al. (1998), since French-civil-
law countries come closer to connmon-law countries

La Porta et al. (1998) classified countries according to the origin of their commercial
laws. All the LAEM are ranked in the French-civil-law group, which proves to give
the weakest legal protection to investors. In addition, the authors did not find a rela-
tion between per capita income and shareholder rights. This result is confirmed in Ta-
ble 2.3, which was elaborated using the information taken from Table 5 of the paper
just cited.

Law enforcement is also a potential determinant of the rights that security holders
have. Weak investor protection can be enhanced with a stronger system of legal en-
forcement since courts can discourage the abuse of shareholders by managers. To ad-
dress this issue. La Porta et al. (1998) examine proxies for the quality of the enforce-
ment of these rights. They use estimates of law and order compiled by private credit
risk agencies. The Law Enforcement Index is calculated using information from Table

^^ For each of the first antidirector rights. La Porta et al. (1998) assign a country a score of 1 if it pro-
tects minority shareholders according to this measure, and otherwise 0. They also give each country a 1
if the percentage of share capital needed to call an extraordinary shareholder meeting is at or below the
world median of 10%. Finally, they combine these six scores into one score.

27
5 in La Porta et al. (1998). First, to get value ranges between 0 and 1, the values of the
variables are divided by 10. Then, by averaging the six variables used, the LE-Index is
computed.

Contrary to most of the other indexes, the LE-Index does not show a heterogeneity
among the LAEM, although Chile continues to be on the top of the list, and Mexico
and Venezuela are actually very close to Chile and Brazil (see Table 2.3). On the
other hand, Peru, the country with the lowest per capita GDP of the seven LAEM, is
now ranked at the bottom of the list. The ranking of the developed countries is the
same as the SH-Index, although the differences are now much smaller. It is also inter-
esting to notice that the quality of law enforcement is higher in all developed coun-
tries. Unfortunately, it is not possible to say whether a weaker legal framework in one
country is offset when its enforcement is of higher quality.

2.5.2 Insider Trading Index

Insider trading usually consists in the purchase or sale of a security, where a fiduciary
duty or other relationship of trust and confidence is breached, and an individual or
firm profits from material or non-public information about the security. Insider trad-
ing violations also include, for example, tipping off investors based on such informa-
tion, trading securities based on such information, and security trading carried out by
any persons who abuse such information.

How insider trading affects stock returns is still discussed in the literature (Meulbroek
(1992)). On the one hand, opponents of insider trading argue that insider trading cre-
ates significantly different stock prices, reduces market liquidity, provides incentives
for abusive managerial practices, and is unfair to uninformed investors. On the other
hand, proponents of insider trading allege that insider trading fosters price discovery
and mitigates incentives for many individuals to collect the same information. Regula-
tors across the world might agree with the opponents of insider trading and rules de-
signed to curb such trading. However, regulation against insider trading might be dif-
ferent in each stock market. To compare it across markets, an Insider Treading-Index
(IT-Index) is computed next.

^* This is the case of most of the LAEM, as we will see below.

28
 i
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•* C\J «3 CJ

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ill
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29
Table 2.3: Law Enforcement Index

Efficiency Risk of con- Rating on

Risk of ex- LE-
of judicial Rule of law Corruption propriation tract repu- accounting Index
system diation standards

Argentina 0,60 0,54 0,60 0,59 0,49 0,45 0,54

Brazil 0,58 0,63 0,63 0,76 0,63 0,54 0,63
Chile 0,73 0,70 0,53 0,75 0,68 0,52 0,65
Colombia 0,73 0,21 0,50 0,70 0,70 0,50 0,56
Mexico 0,60 0,54 0,48 0,73 0,66 0,60 0,60
Peru 0,68 0,25 0,47 0,55 0,47 0,38 0,47
Venezuela 0,65 0,64 0,47 0,69 0,63 0,40 0,58

France 0,80 0,90 0,91 0,97 0,92 0,69 0,86

Germany 0,90 0,92 0,89 0,99 0,98 0,62 0,88
Italy 0,68 0,83 0,61 0,94 0,92 0,62 0,77
United Kingdom 1,00 0,86 0,91 0,97 0,96 0,78 0,91
United States 1.00 1,00 0,86 1,00 0,90 0,71 0,91
Description of the variables: (a) efficiency of judicial system assesses the efficiency and integrity of the
legal environment as it affects business, especially foreign firms; (b) Rule of Law assesses the law and
order tradition in the country; (c) corruption assesses the corruption in government; (d) Risk of Ex-
propriation asses the risk of outright confiscation or forced nationalization; (e) Repudiation of Contracts
by Government assess the risk of a modification in a contract taking the form of a repudiation, post-
ponement, or scaling down due to budget cutbacks, indigenization, pressure, a change in government, or
a change in government's economic and social priorities; and (f) Accounting Standards are represented
by an index that examines and rates companies' 1990 annual reports on their inclusion or omission of
90 items. All variables scale from 0 to 10, where 0 is the worst note and 10 the best. The note is the av-
erage of the 6 variables divided by 10. This data is obtained from Table 2 in La Porta et al. (1998).

The IT-Index is based on results from Bhattacharya and Daouk (2002). They analyzed
the impact of the existence of the law first and then the impact of the enforcement of
the law against insider trading on the cost of equity. They discovered that the estab-
lishment of insider trading laws does not cause a reduction in the cost of equity. How-
ever, they found that there is a statistically and economically significant drop in the
cost of equity after the first insider trading enforcement action. Using this informa-
tion, the IT-Index is estimated. This Index includes two factors: (1) the existence of
laws against insider trading and (2) the existence of prosecutions. The weight of each
factor is determined according to the results of Bhattacharya and Daouk (2002), who
found that the equity cost does not change after introducing insider trading laws, but
decreases after the first prosecution. Twenty percent of the IT-Index is determined by
the existence of laws, while the remaining 80% is determined by the existence of
prosecution.

30
Results of the IT-Index are presented in Table 2.4. The IT-Indexes show that there ex-
ist large differences of law enforcement against insider trading in Latin American
countries. Compared to developed countries, insider trading laws were developed
sooner in the LAEM than in Germany. However, the first prosecution took place only
recently in most of the LAEM (e.g., in Mexico in 2001),^^ while in Colombia and
Venezuela none have been registered thus far. Thus, developed markets enforce better
insider laws than the LAEM. Compared to other emerging markets, all the LAEM
have insider trading laws, while such a law exists in only 80% of other emerging mar-
kets. Furthermore, prosecutions have taken place in 71% of the LAEM, but only 25%
in other emerging markets."^^

Table 2.4: Insider Trading Index

IT-Law First Enforcement Points IT-lndex

IT-Law II First Enforcement

Argentina 1991 1995 0,2 0,8 1

Brazil 1976 1978 0,2 0,8 1
Chile 1981 1996 0,2 0,8 1
Colombia 1990 not enforced 0,2 0 0,2
Mexico 1975 not enforced 0,2 0 0,2
Peru 1991 1994 0,2 0,8 1
Venezuela 1998 not enforced 0,2 0 0,2

France 1967 1975 0,2 0,8 1

Germany 1994 1995 0,2 0,8 1
Italy 1991 1996 0,2 0,8 1
United Kingdom 1980 1981 0,2 0,8 1
USA 1934 961 0,2 0,8 1
The note is obtained by adding the points of the existence and enforcement of insider law. For the ex-
istence of laws again insider trading, a country gets 0.2 points and 0.8 for the existence of the first en-
forcement. The information in columns 2 and 3 is from Bhattacharya and Daouk (1999).

2.5.3 Barriers to Foreign Equity Investment

Interest in emerging markets has grown in recent years as investors try to achieve
higher returns and diversify their portfolios. However, to invest in emerging markets,
investors have to consider some barriers. In most of the countries, there are restric-

Since 2001, 239 indictments have been registered in Mexico (Fernandez-Vega, C , 2002. Mexico
S.A., La Jornada, March 27, 2002, Mexico.). The CNBV has imposed fines on individuals and inter-
mediaries for insider trading and market manipulation. However, the names of the penalized indivi-
duals and intermediaries have not been disclosed, since authorities contend that there have been no suf-
ficient legal grounds to do so.
^^ Information from Bhattacharya and Daouk (2002).

31
tions that are imposed by law or by individual companies (Stulz and Wasserfallen
(1995)).^'^ Barriers imposed by law are usually motivated by the interest in preserving
the independence of industrial sectors that are strategically important to the particular
nation, whereas the management of a company imposes barriers in order to preserve
its powers of decision.

Returns to foreign investors are affected by the investment barriers they confront in
many emerging stock markets. The implementation of these restrictions possibly
causes segmentation since prices for identical claims of cash flows and voting rights
may vary across investor groups (Domowitz et al. (1997)). Thus investment barriers
could render the diversification of benefits and high returns in emerging markets unat-
tainable for international investors.

Research shows substantial influence of investment barriers on share prices (see, e.g.,
Stulz (1981), Bailey and Jagtiani (1994), Domowitz et al. (1997), and Lombardo and
Pagano (2000 and 2002)). Most of the empirical studies on ownership restrictions
have shown that series open to foreign investors yield higher returns than those re-
stricted to local investors. These results are mainly explained by two theories: differ-
ential valuation models and liquidity models. Differential valuation models argue that
differences in prices reflect differences in cost of capital, different investor senti-
ments, taxes, or other factors among local and foreign investors. For example, taxa-
tion of capital gains and dividends used to be lower in the LEAM as in developed
markets. Therefore, the net effect of the Latin American systems of taxation makes
investments in stocks more attractive to local investors. Thus taxes will tend to reduce
the premia of non-restricted shares (Domowitz et al. (1997)). On the other hand, li-
quidity models show that the differences in prices are a consequence of trading costs.
Series restricted to foreign investors are traded less frequently than non-restricted se-
ries.

The Latin American stock markets impose different barriers on foreign investors. The
LAEM permit firms to issue several classes of shares that restrict ownership; never-
theless, the LAEM have been "liberalized" (see Table 2.5). The EMDB includes two
share classes of Argentina, four of Brazil, two of Chile, three of Colombia, three of

^'* Restrictions formerly placed limits on the percentage of equity, which is permitted to be held by a
foreign investor.

32
Mexico, three of Peru, and two of Venezuela. To limit control by foreign investors,
non-nationals can buy only some classes of shares or a percentage of them. For exam-
ple, in Mexico foreigners are restricted to buying only classes B or CPO. Brazil does
not permit that any one foreign shareholder possess more than 5% of the voting
classes or 20% of aggregate capital. In Colombia a single foreigner is not allowed to
possess more than 10% of voting shares, although he can invest in all traded firms.
The LAEM also limit foreign ownership in some sectors, such as financial institu-
tions, energy producers, public utilities, and print and broadcast media.

Table 2.5: Financial Liberalization Dates

Bekaert and Harvey (2000) Buckberg (1995) IFC-Factbook

Argentina Dec. 1989 Oct. 91 Oct. 91

Brazil May 91 May 91 May 91
Chile Apr 90/Jan 92 Oct. 89 Dec 88
Colombia Feb 91 Oct. 91 Feb 91
Mexico May 89 May 89 May 89
Peru
Venezuela Jan 90 Dec. 88 Jan 90
The liberalization dates are from Bakaert and Harvey (2000), Buckberg (1995),
and the IFC-Factbook.

Exchange and capital controls are also two important barriers in most of the LAEM.
These barriers affect repatriation of dividends and capitals. Money-convertibility re-
strictions are imposed especially during periods of crisis. Another way of restricting
capital repatriation is found in Chile, where a minimum investment period is still re-
quired.

To represent the extent to which the Latin American stock markets are open to foreign
institutions, the ratio IFCIMCAP / IFCGMCAP is used, where IFCIMCAP is the
market capitalization in U.S.-dollars of the investable index computed by the IPC, and
IFCGMCAP is the market capitalization in U.S.-dollars of the global index, also
computed by the IPC. This ratio is employed because IFCIMCAP includes only the
market capitalization of securities and their percentages that are legally and practically
available to foreign investors. Stocks included in this index pass the tests for mini-
mum size and liquidity. On the other hand, IFCGMCAP is meant to represent the
broadest capitalization's indicator of the markets. In order to ensure that the IFCG in-
dexes capture the properties of the market, the target market capitalization of IFCG

33
index constituents is between 60% and 75% of the total capitalization of all listed
shares. ^^

Figure 2.6 shows the ratio IFCIMCAP / IFCGMCAP, which represents the Openness
Index (0-Index) from 1988 to 1999. From Figure 2.6 one can see how the LAEM
opened their markets to foreign investments. At the end of the '80s, non-local inves-
tors were permitted to invest in less than 50% of the traded stocks. However, during
the '90s the LAEM gradually relaxed their barriers to foreign investments, and in the
last year of the observed period foreigners could invest in 98% of the quoted stocks.
Contrary to the other indicators, the openness measure is homogeneous across the
markets. Only the Colombian stock market still restricts foreign ownership to no more
than 20%.

Figure 2.6: Stock Market Openness to Foreign Investments

The ratio [Link]/[Link] is used to represent the Openness Index (0-Index) from 1988 to
1999. The [Link] is market capitalization of the investable index of the IFC; it includes only the
market capitalization of securities and their percentage that are legally and practically available to for-
eign investors. The [Link] is the market capitalization of the global index of the IFC-S&P; it is
used to represent the broadest capitalization's indicator of the markets.

2.5.4 Investment Law Index

The IL-Index should help to answer two questions: (1) What are shareholder rights,
law enforcement, insider trading, and barriers to foreign investors in the LAEM? And
(2) how do they compare among the LAEM and with developed markets? To answer

^^ For details on how [Link] and [Link] are computed, see EMDB-International Finance
Corporation, July 1999. The IFC Indexes: Methodology, Definitions, and Practices.

34
these questions, the IL-Index is calculated by averaging the values of the indexes on
investor protection, law enforcement, insider trading, and barriers to foreign investors
(see Figure 2.7 below). The best rating is 1 and the worst is 0. The results for each
market are shown in Table 2.6.
Investment Law Index
(IL-Index)

Sharehol der Index Law Enforcement Index InskJer Trading Index Investment Restrictions
(SH-I ndex) (LE-lndex) (IT-lndex)

[—One share, one vote k-Rule of law k-IT-Law MFCI-MCAP/[Link]

^ Proxy by mail allowed r-Cormption '—First enorcement

1 Shares not blocked _Efficiency of judicial

^ b e f o r e meeting system

[—Cummulative voting —Risk of expropiation

1 Preempty rights to new

—Risk of reputatran
[shares

[_% of shar es to call an Rating of accounting

extraordinary meeting standards

Figure 2.7: Components of the Investment Law Index

The IL-Index is calculated by averaging the values of the indexes on investor protection, law en-
forcement, insider trading, and barriers to foreign investors.

Table 2.6: Investment Law Index

Shareholder Law Enforce- Insider Trad- Investment Re-

Rights ment ing strictions IL-Index

Argentina 0.67 0,54 1 1 0,80

Brazil 0,56 0,63 1 0,94 0,78
Chile 0,78 0,65 1 0,95 0,84
Colombia 0,44 0,56 0,2 0,75 0,49
Mexico 0,22 0,60 0,2 0,99 0,50
Peru 0,67 0,47 1 0,97 0,78
Venezuela 0,22 0,58 0,2 0,98 0,50

France 0,56 0,86 1 1 0,85

Germany 0,22 0,88 1 1 0,78
Italy 0,22 0,77 1 1 0,75
United Kingdom 0,78 0,91 1 1 0,92
United States 0,78 0,91 1 1 0,92
To calculate the Investment Law Index, the values of the investor protection, law enforcement, insider
trading, and barriers to foreign investors index are averaged. The best rating is 1 and the worst 0.

The results of Table 2.6 clearly show that laws that stimulate investments vary in
Latin America. Chile, Argentina, Brazil, and Peru have the highest IL-Index, and Co-

35
lombia, Mexico, and Venezuela have the lowest.^^ Compared to developed markets,
the Latin American group with the highest ratings protects investors as well as they
are protected in Italy, Germany, and France. However, in the UK and the U.S. inves-
tors are much better protected than in any other analyzed market.

2.6 Conclusions
This chapter dealt with the Latin American emerging markets, focusing particularly
on two questions: (1) What are the financial, economic, and political conditions in the
LAEM? And (2) what investment laws do those markets have? To answer the first
question, the political, economic, financial, and composite risk indexes of the ICRG
were compared. For the second question an index was developed that aggregates in-
formation on the existing shareholder rights, law enforcement, insider trading, and
barriers to foreign investors.

The trajectory of the risk indexes clearly supports the hypothesis that the LAEM are
transforming from "less developed countries" into "emerging countries." The risk in-
dexes showed greater increases for the LAEM over the analyzed period, except in the
case of Venezuela. However, the Latin America stock markets are still riskier than the
analyzed developed countries. The ICRG indexes also show that the LAEM are het-
erogeneous. Of the seven LAEM, Chile, Mexico and Colombia are the least risky,
while Argentina, Brazil, Peru, and Venezuela are the riskiest.

The second question studied in this chapter is how investment laws vary across coun-
tries. Empirical research shows that the defining features of securities are influenced
not only by shareholder rights and law enforcement, but also by insider trading and
barriers imposed on foreign investors. Contrary to La Porta et al. (1998), who dis-
cussed shareholder rights, law enforcement, and insider trading each on its own, we
aggregate the information on existing shareholder rights, law enforcement, insider
trading, and barriers to foreign investors into an IL-Index. The development of such
an index makes it easier for investors to interpret the information and compare it

^** The indexes are calculated using information until 1999. If current information were used, the in-
dexes would change.
^^ La Porta et al. (1998) developed an antidirector rights index, which is similar to the SH-Index. The
difference between them is that the SH-Index additionally includes mandatory dividends and the per-

36
Empirical research shows that the defining features of securities are influenced not
only by the shareholder rights and law enforcement, but also by insider trading and
barriers imposed on foreign investors. For this reason the Investment Law-Index was
developed in the second part of this chapter. The IL-Index was calculated by averag-
ing the values of the indexes on investor protection, law enforcement, insider trading,
and barriers to foreign investors.

The IL-Index suggests that the laws that provide incentives for investment vary
among the countries. Chile has the highest IL-Index and is followed by Brazil, Argen-
tina, and Peru. Colombia, Mexico, and Venezuela have the lowest. Compared to de-
veloped markets, Chile has an IL-Index similar to the UK and the U.S. The index
score of Brazil, Argentina, and Peru is comparable to the index score of France, Ger-
many, and Italy. The IL-Indexes of Colombia, Mexico, and Venezuela are much
lower than in any developed country. Indeed, this result differs from those obtained by
the Antidirector-Rights Index of La Porta et al. (1998), according to which investors
in Mexico, Venezuela, Italy, and Germany would have the same rights. The reason for
this lies in the differences showed by each of the four indexes included in the IL-
Index.

In this chapter it was also shown that risk and laws encouraging stock investment in
the LAEM differ significantly from developed markets. Furthermore, among the
LAEM diversification of risk is still possible and investment incentives and restric-
tions still exist. In light of these results, it is necessary to investigate whether the fac-
tors determining the average stock returns in the LAEM are similar to comparable fac-
tors in developed markets. This will be investigated in Chapters 4 and 5. But before
addressing this topic, the cost of trading will be analyzed in the following chapter. It is
relevant because this cost can dramatically reduce the return on an investment.

centage of capital to call an extraordinary shareholder meeting. However, the results do not have an
important impact on the IL-Index.

37
3 An Index Methodology for Analyzing and Comparing the
Development State and Trading Architecture of Stock
Markets

3.1 Introduction
Before participating in a stock market, investors compare it with other stock markets.
For the comparison, three factors are often mentioned in the literature: stock returns,
their associated risk, and the cost of trading. The present chapter concentrates on the
influence of the development state and trading architecture on the trading costs in the
LAEM.^^ The design of indexes has proved to be an efficient way to make compari-
sons between stock markets (Demirguc-Kunt and Levine (1996), Erb, Harvey, and
Viskanta (1996)). By means of indexes, it is possible to answer three questions: (1)
How heterogeneous are the implicit trading costs in the LAEM? (2) How different are
the implicit trading costs of the LAEM from the developed markets? And of consider-
able importance: (3) Which factors are responsible for the differences? To answer
these questions is the chief aim of this chapter. To do so, two main indexes are con-
structed here: the DS-Index and the TA-Index. Because they determine the implicit
costs, the focus in what follows will be on the development state and the trading ar-
chitecture.

The determination of the causes of increased trading costs is important, especially for
illiquid markets, where trading costs can dramatically reduce the return on an invest-
ment. Domowitz et al. (2001) demonstrate that the composition of global efficient
portfolios can change dramatically when trading costs are taken into account. The rea-
son for this is that the perceived gain from international diversification can be im-
pacted if trading cost is included in computations of returns. Comparisons of the ele-
ments that give rise to trading costs across markets are relevant due to the competition
for international capital flows. Large institutional traders tend to concentrate their
holdings in those emerging markets in which the implicit trading cost is low (Do-
mowitz et al. 2001).

Trading cost can be broken down into explicit and implicit costs. Explicit costs are
broker commissions or fees, taxes, etc. Unlike explicit costs, implicit costs are not
represented by visible accounting charges. Implicit costs comprise indirect trading

38
costs, such as the price impact of trading. Of particular interest in the present context
are the implicit costs, since according to the literature they are determined by two
characteristics of a stock market: development state and trading architecture.^^ Fur-
thermore, implicit costs in the LAEM represent a higher percentage of the total trad-
ing costs than in other regions."^^

A large quantity of research analyzes how market development and some elements of
trading architecture affect stock returns. For example, Levich (2001) and Aylward and
Glen (2000) discuss various issues of emerging markets in relation to the importance
of their stock market development and its impact on the international portfolio equity
flows. Regarding the trading architecture of an organized exchange market, Demsetz
(1968) analyzed the importance of market-makers in the trading process. Freihube,
Kehr, and Krahnen (1997) studied how the activities of the Kursmaklers influence the
market liquidity in the German exchanges. Friehube, Krahnen, and Theissen (2002)
analyzed the interaction between market structure, order size, and liquidity.

Hasbrouck and Schwartz (1988) showed that quality of price discovery, opening pro-
cedure, and trading systems have a significant impact on investment returns through
its effects on transaction costs, which could in turn cause intraday price movements to
be excessively volatile. Madhavan (2000) summarized the literature on market struc-
ture and implications on metrics of market quality, such as liquidity and volatiUty.

In order to represent the development state of each of the Latin American stock mar-
kets, we have constructed the DS-Index. Summarizing existing investigations on this
topic, we conclude that market development is a multifaceted concept described by
four market indicators: market size, liquidity, stock market concentration, and number
of quoted firms. These indicators have been computed for the countries under study
here and compared across stock markets in order to determine differences in devel-
opment. Then the DS-Index is calculated by averaging the four development indica-
tors. There is no empirical or theoretical explanation for this way of averaging the in-
dicators; however, as the results show, the DS-Index is robust (see section 3.3.10).

^* Stock returns and their associated risk are the subjects of Chapters 4 and 5, respectively.
^^ The development state and the trading architecture of a stock market might also indirectly influence
explicit cost since authorities usually define commissions and fees by taking into account, e.g., liquid-
ity, market concentration, or costs of clearing and settlement.
^ Explicit costs are not considered in the present study since they are determined by fees and taxes,
which in many cases are simply imposed by the governments.

39
The consolidation of organized securities exchanges is becoming increasingly fre-
quent. This motivates a continuous implementation of new market participants, new
trading mechanisms commonly based on electronic systems, and improvements to
their central securities depositories and registries. Therefore, the Latin American trad-
ing architectures must be evaluated with the aid of a methodology that is brought up
to date periodically.

The trading architecture of the Latin American stock markets is analyzed and com-
pared by means of the constructed TA-Index. Three elements play a role in the trading
process: market intermediaries, trading systems, and central securities depositories
and registries. For each element we compute an index: the Intermediary Index (I-
Index), the Trading System Index (TS-Index), and the Custody, Clearing, and Settle-
ment Index (CCS-Index). Then the TA-Index is calculated by averaging these three
indexes.

The remainder of this chapter is divided into four sections. In 3.2 information on trad-
ing costs is presented and compared across the analyzed stock markets. In 3.3 four
stock market development indicators are calculated and discussed. In 3.4 trading ar-
chitecture is presented in two subsections (3.4.1 and 3.4.2). In the first an analysis and
comparison of the evolution and current state of the stock trading architectures across
the LAEM and developed markets is carried out. This subsection falls into three parts:
stock market intermediaries, trading systems, and depository, clearing, and settlement
process. In 3.4.2 the TA-Index is calculated by averaging the three indexes computed
in 3.4.1 (I-, TS-, and CCS-Indexes). Finally, in 3.5 conclusions are presented.

3.2 Trading Costs across Latin American Stock Exchanges

Transaction costs are another important characteristic that distinguish emerging from
developed markets. For the period from September 1996 to December 1998, Do-
mowitz et al. (2001) calculate a list of one-way equity trading costs using information
from Elkins & McSherry. They compute explicit costs (brokerage commissions, fees,
taxes) and implicit costs (impact of trading on stock prices). Domowitz et al. (2001)
discover that transaction costs in emerging markets are significantly higher than in
developed markets, even after correcting for factors affecting costs, such as market

40
capitalization and volatility."^^ Furthermore, their results show the importance of im-
plicit costs, which represent one-third of the total cost.

Table 3.1: Trading Costs

Quarterly Re-
Total Trading Cost Explicit Cost Implicit Cost
turn

Buenos Aires 76,9 47,3 29,6 725

Sao Paulo 58,0 36,7 21,4 551
Santiago 84,3 45,7 38,6 423
Colombia 97,5 55,3 42,2 693
Mexico 61,7 34,4 27,3 383
Lima 95,8 60,6 35,2 301
Caracas 134,1 99,4 34,7 757
Mean 86,9 54,2 32,7 547,6
Std. Dev 25,8 22,0 7,1 182,5
Min 58,0 34,4 21,4 301
Max 134,1 99,4 42,2 757

Paris 29,5 22,8 6,7 294

Frankfurt 37,7 24,3 13.4 333
London 54,5 39,3 15,2 296
USA 38,1 8,3 29,8 374
Mean 40,0 23,7 16,3 324,3
Std. Dev 10,5 12,7 9,7 37,7
Min 29,5 8,3 6,7 294
Max 54,5 39,3 29,8 374
Source of the information is Domowitz et al (2000). The one-way trading costs are represented in ba-
sis points for active managers from September 1996 to December 1998 based on quarterly data from
Elkins/McSherry Co., Inc. Explicit costs include commissions and fees. Market impact costs (a com-
ponent of implicit costs) are computed by comparing the trade price to a benchmark price on the day
of the trade. Data for the U.S. represents average costs across Amex, Nasdaq, and NYSE markets.
Quarterly return is from 1990 to 1998.

Table 3.1 reports the average one-way implicit, explicit, and total equity transaction
costs for the seven Latin American and the four developed stock markets from Table
1 in Domowitz et al. (2001). An enormous variation in trading costs across markets is
observed. Trading costs range from 30 basis points (bp) in Paris to 134 bp in Caracas.
Across Latin American markets, trading cost varies from 58 bp in Sao Paulo and 61.7
bp in Mexico to 97.5 bp and 134 bp in Colombia and Caracas, respectively. The
equally weighted portfolio of the Latin American markets has a one-way trading cost
of 86.9 bp compared to 40 bp of the four developed markets. If these portfolios turn
over two times per year, the annual average trading costs will be 347.6 bp for the

*^ High trading cost in the LAEM motivate firms to issue, e.g., ADRs in the U.S. markets or to list their
shares abroad.

41
LAEM and 159.8 bp of the developed markets. Of the average annual portfolio return,
trading costs constitute 16% in the LAEM and 12% in the developed markets.

The variation in the composition of trading costs across Latin American and devel-
oped stock markets is not very different. Explicit costs represent 62.4% in the LAEM
and 59.3 in the developed markets, while implicit costs made up 37.7% in the LAEM
and 40.7% in the developed markets. Across the LAEM, the cost components are het-
erogeneous. Explicit cost is low in Mexico (34.4 bp) and high in Caracas (99.4 bp),
while imphcit cost is low in Sao Paulo (21.4 bp) and high in Bogota (42.2 bp).

3.3 Development Indicators of the LAEM

In this section a development index with five development indicators for the seven
largest Latin American stock markets, France, Germany, the UK, and the U.S. is con-
structed and discussed. The analysis of development indexes is important since, to-
gether with the trading architecture, they impact on the implicit trading costs.

The goal of this section is threefold: (1) to determine how developed the LAEM are
compared to the most developed markets, (2) to investigate the development hetero-
geneity among the LAEM, and (3) to determine reasons for the differences. To
achieve these goals, this analysis follows the recent literature. The existing investiga-
tions point out that stock market development is a multifaceted concept (Demirgiic-
Kunt and Levine (1996)). As a consequence, no single indicator will completely de-
scribe stock market development. For this reason, four development indicators and
one index (compounded from the four indicators) are discussed with regard to and
compared among the analyzed markets below.

Due to the fast changing conditions of emerging markets, the development indicators
are discussed for a period of several years. The sample period varies among the mar-
kets. For Argentina, Chile, Colombia, Mexico, and Venezuela the analyzed period
runs from 1986 to 1999, while for Brazil and Peru indicators are observed over dif-
ferent periods."^^ For France, Germany, the UK, and the U.S., the sample period runs
from 1990 to 1999. The information source for the LAEM is the EMDB; for devel-
oped markets it is the International Federation of Stock Exchanges (FIBV). Informa-

The analyzed periods for Brazil are from 1986 to 1999 for TO and number of quoted firms, and from
1994 to 1999 for MC/GDP and value traded. For Peru, the time periods are from 1986 to 1999 for
MC/GDP, value traded, and number of quoted firms and from 1994 to 1999 for TO.

42
tion on market capitalization, value traded, turnover, and number of quoted firms be-
long to the most important stock exchange of each country, except the U.S, where in-
formation on Amex, Nasdaq, and NYSE is included on account of the significance of
the stock exchanges."^^ To determine the stock concentration of stock exchanges, in-
formation is used from 1995 to 2001 for only five Latin American"^ markets and for
five developed markets.

The remainder of this section is divided into five subsections. In the first, for each
country the stock market size indicator is computed and discussed, while the liquidity
indicator is examined in the second. The same approach is taken regarding the indica-
tors of stock market concentration and number of quoted firms in the third and fourth
subsections. Finally, after compounding these indicators, the development index is
calculated and compared among the markets.

3.3.1 Stock Market Size

The ratio of market capitalization over Gross Domestic Product (MC/GDP) is the first
indicator. The literature calls this ratio "Stock Market Size." The Stock Market Size is
important because of its possible correlation with the ability to mobilize capital
(DemirgUc-Kunt and Levine (1996)). This ratio has several interpretations. (1) Ana-
lysts use it as a measure of stock market size. (2) MC/GDP also represents financial
depth. (3) If market development and long-run growth are positively related (Levine
and Zervos (1996)), MC/GDP will also be a proxy of the stage of economic develop-
ment. In that case, as the economy develops, we would expect the market to grow in
size and in depth."^^ And, very important, (4) this ratio is also viewed as an inverse in-
dicator for trading costs: an increase in financial depth is expected to cause a decline
in transaction cost (Aylward and Glen (2000)).

^^ From 1990 to 2000, 47% of the value traded occurred on Amex and Nasdaq; 71% of firms quoted
here represented 19% of market capitalization.
^ The FIBV does not report information on the Colombian and Venezuelan stock markets. For this
reason neither was included.
^^ It is also assumed that more mature economies rely more on equity markets (Boyd and Smith
(1996)).

43
 Arg Bra Chi Col Mex Peru Ven Fran Ger

Figure 3.1: Stock Market Size (MC/GDP)

The market capitalization is from the EMDB for the LAEM and from FIBV for the developed countries.
The GDP is from the IMF.

From Figure 3.1 one can see that since 1986 all LAEM were involved in a transforma-
tion process. In the late 1980s and throughout the 1990s, MC/GDP increased signifi-
cantly in the LAEM. Specifically, the stock market size reached a peak between 1993
and 1994 in most of the LAEM. As a consequence of the crises in Mexico, Asia, Rus-
sia, and Brazil, from 1995 to the first part of 1999 stock market size diminished.
However, it began to increase in the second part of 1999. Compared to developed
markets, this ratio is significantly lower in most of the Latin America markets. Chile
is the only stock market in the LAEM that has a MC/GDP comparable to Germany's.
Mexico has also a high ratio, but it is significantly lower than Chile's.

3.3.2 Liquidity

Market liquidity is the second indicator of market development. While several defini-
tions of liquidity may be found in the literature, all of them refer to the ability to buy
and sell stocks. According to theory, greater liquidity means that stocks can be ex-
changed easily and cheaply, investments are less risky, more profitable, and longer
term. Thus a negative link between liquidity and the cost of trading is expected. Li-
quidity is an important development indicator because it influences the allocation of
capital.
It is difficult to find a measure that represents liquidity since all costs associated with
trading must be quantified: time cost, counterpart cost, and settlement cost (Demir-
guc-Kunt and Levine (1996)). Because data is very hmited, the comparison of stock
markets is our principal goal here. To do this, two measures of liquidity are used: the
ratio of the value of all stocks traded in a year over the GDP (VT/GDP) and TO, the
annual value of total shares traded as a percentage of market capitalization. Both li-
quidity measures are related to transaction costs.

Panel a) VT/GDP

Figure 3.2: Liquidity

The volume traded and market capitalization arefromthe EMDB for the LAEM andfromFIBV for the
developed countries. The GDP isfromthe IMF.

45
It is important to analyze both liquidity measures because they are complementary
and can move in contrary directions. VT/GDP explains trading compared with the size
of the economy, and TO captures trading compared to the size of the stock market.
For example, it is possible for a large economy with a small market to have a low
VT/GDP and a high TO if its market is active.

The behavior of VT/GDP and TO substantially varies over time and across the Latin
American markets. From Figure 3.2 one can observe that in the late 1980s and at the
beginning of the 1990s VT/GDP increased significantly, while TO did not show this
tendency. In most of the Latin American stock exchanges, VT/GDP attained a maxi-
mum between 1994 and 1995. At that time and during the years following, this ratio
diminished, although it began to increase in 1999 in Chile and Mexico. During the
analyzed period, Brazil (14.95%), Chile (8.49%), and Mexico (11.7%) have the high-
est VT/GDP, while in Argentina (3.9%), Colombia (1.6%), Peru (3.4%), and Vene-
zuela (2.9%) the VT/GDP is the lowest. On the other hand, from 1990 to 1999 TO is
considerably higher in Argentina, Brazil, and Mexico; these averages are higher than
in Japan (30.8), though they are still lower than in the U.S. (81.18%), Germany
(121.8%), and the UK (86.9%). Compared to developed markets, the VT/GDP ratio is
also much lower in the LAEM. These results suggest that liquidity varies across mar-
kets. However, liquidity can also vary within a market, since a small number of highly
capitalized firms usually have considerable liquidity (see the following subsection).

3.3.3 Stock Market Concentration

Market concentration is another important development indicator. It shows the extent

to which a stock market is dominated by only a few companies. A high concentration
is not desirable for an exchange since it might have a negative influence on the liquid-
ity of the market and on trading costs. In the literature, two different definitions of
market concentration exist: the first is taken from the FIBV and the second is stated
by IFC-S&P, mainly for emerging markets. For five of the LAEM,"^^ in the present
subsection we show the results of both definitions, each of which has two alternatives.
Furthermore, market concentrations of the Latin American exchanges are compared
with those of the five most important stock exchanges (Frankfurt, London, Nasdaq,
NYSE, and Tokyo).

46
According to the FIBV's definition, market concentration is the percentage of market
capitaUzation of the largest 5% of all firms. Taking this measure, market concentra-
tion in Latin America is heterogeneous (see Table 2.2). At the beginning of the ana-
lyzed period, the stock markets in Buenos Aires, Sao Paulo, and Lima had a concen-
tration of about 70%, while the concentration in Santiago and Mexico was 50%. Dur-
ing the analyzed period, Buenos Aires, Sao Paulo, and Mexico converged to a concen-
tration of around 60%, while Santiago remained at 50%.

The FIBV's concentration measure is heterogeneous across the Latin American and
the developed markets. Mexico has a concentration tendency similar to that of the
NYSE and Nasdaq, while Buenos Aires, Sao Paulo, and Lima has one similar to
Frankfurt's. The source of the large difference between the Latin American and the
developed markets is the number of firms that represent 5% of the market capitaliza-
tion. The market with the highest number of firms in Latin America representing 5%
of market capitalization is Sao Paulo (25 on average over the period). This number is
not much lower than the number for the Frankfurt stock exchange (29 on average over
the period). ^'^

The percentage of value traded by the largest 5% of all firms is an alternative measure
of market concentration. For Latin America this alternative measure of concentration
confirms some results for the previous indicator. (1) At the beginning of the period,
Buenos Aires, Sao Paulo, and Lima have a concentration that is much higher than in
Santiago and Mexico. (2) However, as time passes, concentration in Buenos Aires,
Sao Paulo, and Lima diminishes, while it increases in Santiago and Mexico. In the
five Latin American markets, the indicator seems to converge to around 70%. In con-
trast to the first concentration indicator, this alternative measure of the LAEM is not
as heterogeneous as in the developed markets. This variable has a different trajectory
in each developed market.

The stock exchanges of Colombia and Venezuela are not included since the FIBV does not report
information on them.
^"^ In Frankfurt the average is so low because in 1997 and 1998 only 13 and 12 firms, respectively.
made up 5% of the market capitalization.

47
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49
IFC-S&P measures concentration for emerging markets differently than does the
nVB. Market concentration is the percentage of market capitalization of the largest
ten quoted firms. According to this definition, stock market concentration also varies
among the LAEM. Once again, Sao Paulo and Santiago have the lowest concentra-
tions, while Buenos Aires, Mexico, and Lima show the highest. In comparison to de-
veloped markets regarding this measure, only Sao Paulo and Santiago have concentra-
tion levels similar to Frankfurt's, the exchange with the highest market concentration
of the developed markets analyzed. The last part of Table 2.2 shows a final alternative
to measure concentration: the turnover value of the largest ten quoted firms. Using
this alternative measure, it is possible to observe that the market concentration in the
LAEM is much higher than in the developed markets.

Taking into account these four concentration measures, we may conclude that concen-
tration varies. It is possible to observe that (1) concentration is significantly higher in
the LAEM than in developed markets and that (2) the Santiago stock exchange has the
lowest concentration and in recent years it was similar to the concentration of the de-
veloped markets. To a lesser extent, Sao Paulo also exhibited a diminished concentra-
tion.

3.3.4 Number of Quoted Firms

Figure 3.3: Number of Quoted Firms

These graphs have been constructed based on information from the IFC (for the LAEM) and FIBV
(for the developed markets).

50
Finally, the fourth market development indicator is expressed by the number of
quoted firms (NQF). This proxy is included because it represents the prevalence of
public financing. Furthermore, NQF is sometimes used as an additional measure of
market size. The number of quoted firms shows the different development states
among the Latin American stock markets. While it tended to diminish over the period
in Argentina, Brazil, and Venezuela, NQF rose in the other four markets and most of
the increment took place between 1986 and 1994 (see Figure 3.3). Among the Latin
American markets, Brazil has the highest NQF: 486 in 1999, which is half of that of
Germany and only 5% of the firms traded in the U.S.

The market capitalization per firm is also an interesting aspect. In the LAEM the av-
erage capitalization per firm over the sample period is smaller than in the markets of
the developed countries under analysis. Among the LAEM, however, considerable
variation exists. The average market capitalization of Mexican firms over the period
1990-1999 (US$ 622.6 million) is the highest in Latin America and is even higher
than in several developed markets, such as Canada (US$ 312.2 million) and New Zea-
land (US$ 132.6 miUion), and very close to the UK (US$ 624.1 milHon).

3.3.5 Composite Index of Stock Market Development

Once again, the development of a DS-Index is the main goal of this section. The DS-
Index should help to answer three questions: (1) How underdeveloped are the LAEM
compared to the most developed stock markets? (2) How heterogeneous are the
LAEM? And (3) what are the determinants of the differences? The computation of the
index involves two steps. First, the mean-adjusted market capitalization, VT/GDP,
TO, NQF, and market concentration are computed for each market. The mean-
adjusted value of a development indicator X for country / is defined as:

Xp =[X. - mean (X)]/mean (X) (3.2)

where mean(X) is the average value of indicator X across all countries over a period of
time. The mean-adjusted value of the market concentration measure is multiplied by
(-1) since larger numbers correspond to lower stock market development. The second
step is to take a simple average of the mean-adjusted market capitalization. Liquidity
{(VT/GDP+T0)/2), market concentration, and NQF (see Figure 3.4). Due to a lack of
information, the DS-Index is calculated only from 1995 to 1999.

51
 Development State Index
(DS-lndex)

stock Market Size Liquidity Market

Nr. Quoted Firms
(MC/GDP) (VT7GDP + TO)/2 Concentration
Figure 3.4: Components of the Development State Index
The DS-Index is calculated by averaging the mean-adjusted market capitalization, liquidity, market
concentration, and NQF

For market concentration, the percentage of value traded by the largest 5% of all firms
is used, since nowadays this is the most common measure of concentration. For Co-
lombia and Venezuela, the FIBV does not include data on market concentration, and
so market concentration for these countries is calculated using information of the
EMDB.

Table 3.3: Development State Index

1995 1996 1997 1998 1999

Buenos Aires -0,66 -0,68 -0,50 -0.60 -0.60

Sao Paulo -0.37 -0,29 -0,24 -0,30 -0.33
Santiago -0,02 -0,19 -0,31 -0,42 -0.42
Colombia -0,65 -0,68 -0,65 -0,66 -0.69
Mexico -0,33 -0,32 -0,38 -0,52 -0.47
Lima -0,45 -0,52 -0,57 -0,60 -0.59
Caracas -0,71 -0,65 -0,57 -0,74 -0.75

Paris -0,22 -0,19 -0,15 -0,04 -0.06

Frankfurt 0,22 0,26 0,11 0,32 0.25
London 1,37 1,33 1,27 1,48 1,36
New York 1,88 1,99 1,99 2,07 2.30
The computation of the index involves two steps. First, the mean-removed market capitalization,
VT/GDP, TO, NQF, and market concentration are computed for each market. The mean-removed
value of the market concentration measure is multiplied by - 1 since larger numbers correspond to
lower stock market development. The second step consists in taking a simple average of the means-
removed market capitalization, VT/GDP, TO, and NQF.

Table 3.3 reports the values and rankings of the DS-Index for each country. This in-
dex shows that the LAEM are heterogeneous. For 1999 Brazil had the best rating, fol-
lowed by Chile and Mexico. On the other hand, Venezuela had the worst rating, fol-
lowed by Colombia, Peru, and Argentina. During the analyzed periods, the markets
changed places but not the group, that is to say, during the period Brazil, Chile, and

52
Mexico are always among the first three markets, while the other four always occupy
the last four places. Among developed markets, the U.S. has the most developed stock
market, followed by the UK, Germany, and France. In comparison with developed
markets, all the LAEM have considerably lower ratings than developed markets in
each period.

To obtain a longer period, a second DS-Index is computed that excludes market con-
centration. This version of the DS-Index shows the same results, except that the dif-
ferences between the development indicators become larger."*^ The results of both in-
dexes are similar. Indeed, the developed markets are more developed than the LAEM,
and the LAEM are heterogeneous. Three (of four) development indicators support
these results: market size, liquidity, and the NQF. Only the market concentration does
not differ significantly between Latin American and the developed markets.

3.3.6 Stock Trading Architecture

Trading architecture can be understood as the participating elements that make the
trading process possible. In any stock exchange, the trading process can be divided
into three phases. First, investors buy and sell securities by means of intermediaries in
a given country's stock exchangeCs)."^^ Second, orders are transmitted from the inter-
mediaries' headquarters to the stock exchange's central order book via the trading
floor or electronic trading system (ETS) for equities, where they are matched with a
similar but opposite order, if there is one. And third, a few business days after the
transaction has been completed, the Central Securities Depositories-registries (CSDs),
upon receiving instructions from the selling brokerage firm, transfer the securities
from the selling brokerage firm's account to the buying brokerage firm's account. The
corresponding funds are transferred from the buying brokerage firm's cash account to
the selling brokerage firm's cash account.

To analyze and compare the trading architectures, three indexes are constructed in this
section, one index for each market participant: the I-Index, the TS-Index, and the
CCS-Index. Then the TA-Index is calculated by averaging these indexes. The averag-
ing procedure of the elements does not follow a theoretical or empirical foundation,
but it is based on the author's own criteria, which are based on the literature of trading

^^ The second version of the DS-Index is presented in Appendix 2.

^^ And if permitted by law, in the stock markets of other countries.

53
architecture. The results of 3.3.10 show that the averaging method is robust. However,
if we continue calculating the indexes for the subsequent years, we can test if this way
of averaging continues been correct, and if it does not, then the averaging procedure
can be easily changed.

In the next sections, the importance and the role of the stock market intermediaries in
Latin America is first discussed and then their trading systems, as well as their deposi-
tory, clearing, and settlement processes, are compared.

3.3.7 Stock Market Intermediaries

Intermediaries are fundamental to a well-functioning trading system. In all the stock

exchanges of Latin America, two types of intermediaries exist: the brokerage firms or
brokers and the market-makers.^^ The role of intermediaries depends on the system
used for trading. Since all the LAEM use order-driven systems, the problems in the
trading system and the functions of the intermediaries should be similar. In this sub-
section we investigate whether this conclusion bears out. First, some problems of the
stock trading systems are briefly presented. Then we investigate whether the functions
of intermediaries are the same in each market. Finally, an I-Index is calculated in or-
der to compare the role of the intermediaries among the stock markets.

Stock exchanges exist because they facilitate the transactions of stocks between buy-
ers and sellers. To facilitate this saving-investment flow, all Latin American stock ex-
changes have introduced order-driven systems. However, order-driven systems face
problems. Some of the most important are: (1) short-term price fluctuations,^^ (2) in-
creasing dominance of order flow by institutional participants (see Becker and Ang-
stadt (1995)),^^ and (3) the concentration of trading in some stocks.^^

There are mainly two solutions to these problems. First, in most of the developed
markets brokerage firms are allowed to buy and sell stocks on their own behalf and

^ It was not possible to get information on market-makers in Buenos Aires.

^^ In their centralized and automated trading systems, the brokers input into the system the investors'
bids and offers (see 2.2.2, above). Orders are matched when a similar but opposite order is received.
However, if there are no orders on the opposite side, the intermediary has to wait until one arrives. This
waiting time may cause short-term price fluctuation.
^^ Institutional order flow is more difficult to handle because it is usually one-sided and the orders are
large. Therefore, prices become more volatile and the time needed to execute an order increases.
^^ The great number of stocks listed in exchanges does not allow all stocks to be traded continuously. It
makes some stocks less liquid. Evidence from the developed markets shows that most of the stocks re-
port few operations and that the trades are spaced over time.

54
not only for a third party, since this provides a means of partially diminishing price
volatility. Second, to improve liquidity and diminish the time needed to trade an order
(immediacy), continuous order-driven markets allowing the participation of market-
makers have been introduced. Market-makers play a significant role in the determina-
tion of prices because they play the key role of price-setters. Since they are willing to
buy or sell securities, they provide liquidity to the market and permit continuous trad-
ing. However, the benefits from the incorporation of market-makers are still contro-
versial.^"^ For example, Madhavan (2000) states that market-makers can alter prices in
response to considerations of their inventory and information.

As mentioned above, in the LAEM there are two types of intermediaries: the broker-
age firms or brokers and the market-makers. The name of the brokerage firms may
vary across the exchanges of Latin America and developed markets, but not their ob-
ligations and privileges. To be registered as a brokerage firm, a number of require-
ments - such as qualification, solvency, moral and net worth - should be met. As
compensation, they are allowed to be members of the stock exchanges and to buy and
sell stocks by themselves and for third parties in every market of their country.^^ Since
the functions (privileges and obligations) of brokerage firms do not vary among the
analyzed markets, they are not included in the I-Index.

Since stock trading is also concentrated in the Latin American stock exchanges on a
few stocks (see section 3.3.3, above), all stock exchanges have introduced market-
makers. They were introduced in order to increase the liquidity of the less frequently
traded stocks. The exception is Santiago, where each stock can register a market-
maker.

The bid-ask spread and its determinants are defined in different ways in the LAEM. It
is generally believed that the bid-ask spread determined under perfect competition is

^^ The analysis of the importance of market-makers in the trading process is not new. Demsetz (1968)
showed that market-makers receive the bid-ask spread as the premium for their predictive immediacy
services. The bid-ask spread is important because it is part of intraday price dynamics. Smith (1971)
extended the analysis of the market-makers. He argued that the primary activity of the market-makers
remains the supply of immediacy, but they are also active in the price-setting process in order to adjust
their inventories. It implies that prices may depart from their expected values if the dealer position dif-
fers from their target, thereby giving rise to transitory price movements over the course of the day and
possibly over longer periods. More recent studies have considered the impact of information on market
prices. Informed traders expect to make profits from uninformed traders. Market-makers will on aver-
age lose with informed traders and win with uninformed ones, which suggests that an informational
component might be contained in the spread (Glosten and Milgrom (1985)).
^^ They can buy or sell stocks, but they need not.

55
the reward of market-makers for the immediacy they provide. For example, Freihube,
Krahnen, and Theissen (2002) find by means of experimental studies that the role of
market-makers will be beneficial only if they are subject to competition. All Latin
American exchanges, except Colombia's, permit more than one market-maker per
stock. But this does not guarantee the conditions of perfect competition that would
justify considering the bid-ask spread in these markets to be the fair reward to mar-
ket-makers. In Santiago, Mexico, and Lima, a council estabUshes the bid-ask spread,
the smallest lot, the minimum number of stocks to sell and buy, and the time duration
of the orders posted by the specialist according to liquidity, free floater, antiquity, and
volatility. In Sao Paulo and Colombia the council only establishes the minimum level
of demand and supply.

The compensations received by the market-makers for their services also vary across
the Latin American exchanges (see Table 3.4). Market-makers in Santiago do not pay
trading fees, while in Colombia they can trade directly with investors and outside of
the exchange. In Mexico and Caracas the only remuneration for the market-makers
(called especialistas) are the bid-ask spread. In Lima market-makers (called promot-
ers) do not pay trading fees and can also trade directly with the investors, as in Sao
Paulo. Another compensation for market-makers in each LAEM is that they are al-
lowed to specialize in more than one stock.

The Intermediary Index

Since the role of intermediaries in the continuous order-driven systems is fundamental
for a well-functioning market, an I-Index is computed and will be included in the
TA-Index. As was seen above, two types of intermediaries exist in all analyzed stock
markets: the brokerage firms or brokers and the market-makers. Furthermore, it was
shown that while the functions (privileges and obUgations) are similar across the ex-
changes for brokerage firms, they are not contained in the I-Index. Therefore, only the
characteristics of market-makers are included in the I-Index.

The I-Index is calculated using information from Table 3.4. Stock exchanges have
imposed some obligations on and given some privileges to market-makers. The seven
obligations and privileges included in the I-Index were identified as the most impor-
tant by Demarchi and Foucault (1998). Information for these variables is obtained
from the web pages of the Latin American stock exchanges. To compute the I-Index,

56
each obligation or privilege gets one point, since each of them induces competitive-
ness by augmenting liquidity and diminishing trading costs. Then the points for each
market are added up and divided by seven.

Table 3.4: Market-Makers and Intermediary Index

Privileaes Obligations l-lndex

<D <D (D

ill >> >

II to c -S
•C (g O "O <2
® (0 TO
1 Q.2
If ^ £o i°- E D O
Points Note

Ill H5
CO <D
w | 8 SI'S

Buenos Ai-
res NA NA NA NA NA NA NA NA NA
Promotor X X X X 4 0,57
(Sao Paulo)
Market Maker X X X X X 6 0,86
(Santiago)
Comisionista X X X 3 0,43
(Colombia)
EspecialJsta X X X X 4 0,57
(Mexico)
Promotor X X X X X X 6 0,86
(Lima)
Corredor X X 2 0,29
(Caracas)

Animateurs X X X X X 5 0,71
(Paris)
Betreuers X X X X X 5 0,71
(Frankfurt)
London
(RSP or PT)
Points are obtained by adding the existing privileges and obligations of market-makers in each market.
To compute the note, the number of points is divided by 8 (the maximum number of points a market can
achieve). The information was recollected from the web-pages of the stock exchanges.

The I-Index is shown in the last column of Table 3.4. The I-Index shows two results.
First, the obligations and privileges of market-makers varies across Latin American
exchanges. The tasks of market-makers in Chile and promoters in Peru are alike. In
the other group (Colombia and Venezuela) the role of market-makers needs to be rein-
forced, and to a lesser extent in Sao Paulo and Mexico. Second, the tasks of market-
makers in Chile and promoters in Peru are also similar to the duties of the animateurs
at the Paris Bourse, one of the most important order-driven markets around the world.
To some extent, they are also similar to the Betreuers of Frankfurt.

57
3.3.8 Trading Systems

Initially, the literature was focused on the role that intermediaries play in the process
of price formation. However, the interest of researchers in the trading systems grew
quickly, since they recognized the systems' influence on the "price discovery" proc-
ess.^^ Usually, stocks are traded on electronic systems or on the floor by the tradition-
ally open outcry mechanism. Each system has such different characteristics that the
price formation process varies. Even small differences between electronic systems
might cause differences in trading cost and risk. As a consequence, some of the most
important characteristics of each trading system in Latin America and three of the
most representative developed markets are analyzed and compared here. To compare
the trading systems more effectively, a Trading System Index (TS-Index) is calcu-
lated.

In this section, a brief sketch is given of the development and current state of the most
important trading systems of the Latin American stock exchanges. The first subsec-
tion describes the alternatives for negotiating stocks (trading mechanisms and types of
orders). In the second subsection, the most important features of the ETS are de-
scribed. These systems are compared to those of developed markets. Finally, the mar-
ket segmentation of the LAEM is discussed. Yet prior to doing so, a short history de-
velopment of the ETS in Latin America is presented. The section is organized in this
way in order to highlight the differences in the systems that can give rise to additional
costs or risks in the transactions.

[Link] Market Segmentation

Stock markets usually segment their stocks by their liquidity and/or their market capi-
talization and/or their order size. The reason for this is that most of the stock markets
are confronted with a diversity of stocks that vary in size and liquidity and with a
wide range of order sizes. To reduce transaction costs and sources of risk, a specific
trading mechanism for each segment is commonly developed.^^

Two questions are answered in this subsection: (1) How do the Latin American ex-
changes segment trading? And (2) which trading mechanism is used for each seg-

^^ For a discussion of other factors that influence market equilibrium prices see, e.g., Madhavan (2000)
and Pohletal. (1995).

58
ment? These questions are important to the LAEM since they have the same problems
as developed markets (trade is concentrated in some stocks and large orders) plus an
additional one (fewer stocks are quoted on the LAEM). Under these conditions it is
interesting to know how the Latin American exchanges adapt their trading systems in
order to reduce transaction costs and sources of risk. In the next subsection, the alter-
native methods of negotiating stocks (trading mechanisms and types of orders) are
compared first and then the criteria used by the Latin American exchanges to segment
their stock markets.

Alternatives of Stock Negotiation

Stocks are traded either on electronic systems or on the floor by the traditional open
outcry mechanism, though in some markets both are used. The trading forms used to
negotiate stocks vary among the Latin American exchanges and among developed
stock exchanges (see Table 3.5). Two groups of stock exchanges can be discerned. In
the first (Bogota, Mexico, and Caracas) trading is concentrated on electronic systems,
while in the second group (Buenos Aires, Sao Paulo, Santiago, and Lima (and, of the
developed markets, only Frankfurt) stocks can be traded either on the floor or on ETS.
In the exchanges where both mechanism coexist, prices are linked. In Table 3.5 it is
also shown that only the most liquid stocks are traded on the floor.

The types of orders also influence the price formation process. Therefore, the different
types of stock orders that can be routed through the trading systems are also com-
pared. The determination of the basic set of orders is based on Demarchi and Foucault
(1998). But we have added three types of orders to that set: specific time, hidden vol-
ume, and block orders. In Table 3.6 the set of orders is shown to which traders have
access in each stock market, and each order type is defined in the lower portion of the
table. It should be noted that the variety of orders traded varies across the markets. As
in Paris and Frankfurt, more than seven types of orders can be placed in Buenos Aires,
Sao Paulo, Mexico, and Caracas, while in London, Santiago, Colombia, and Lima
only five types are accepted.

^^ After analyzing the interaction between market structure, order size, and liquidity, Freihube, Krah-
nen, and Theissen (2002) conclude that "all auctions are best suited to small orders."

59
Table 3.5: Trading Mechanisms

Deve-
Trading Traded Imple.
Coexistence Priority Rules lop-
System Stocks Date
ment

Simultaneous
Concurrent Most Liquid Most Liquid
Buenos Aires Stocks
Sinac All Price and time 1996 Own
Simultaneous
Floor Most Liquid Most Liquid
Stocks
Sao Paulo With
Paris
Mega Bolsa All Price and time 1997
Ex-
change
Simultaneous
- ,. Pregon Most Liquid Most Liquid
Sa"t'ag° stocks
Telepreg6n All Price and time Own
Colombia Electronic All
Mexican Sentra All Price and time 1997 Own
Floor
Lima Effectinv
Elex All Simultaneous Price and time 1995 est AG,
Wien
Madrid
Caracas Sibe All Price and time 1999 Ex-
change

Paris NSC All 1994 Own

Floor All
Frankfurt
Xetra All 1997 Own
Sets FTSE100 1997 Own
Seaq Large/Medium 1986 Own
London
Seaq-1 Foreign 1985 Own
Seats-Plus Small Own

The information is from the home pages of the exchanges of the LAEM and from Demarchi and Fou-
cault (1998) for the European stock markets. In the first row of each exchange are shown the character-
istics of the floor trading system, if it still exists and the properties of the electronic trading systems are
given in the second row of the exchange.

Segmentation

Trading segmentation is not as common in the LAEM as it is in developed markets.

The exchanges of Colombia, Lima, and Caracas do not provide a specific trade
mechanism by types of stocks or orders. All the stocks and orders are traded in a con-
tinuous electronically driven market. In Lima stocks can also be traded on the floor.

60
The Merval is the only exchange that segments its market by the capitalization of its
stocks. It has three segments: Special, General, and New Projects. In El Mercado Es-
pecial only large firms are traded. El Mercado General includes small firms, while
Mercado de Nuevos Proyectos is developed for high-growth firms. There are some
differences in the trading mechanisms used in each market. The largest firms can
trade on the Sinac and on the floor. The stocks of the Mercado General and the
Mercado de Nuevos Proyectos can be negotiated only on the Sinac, but market-
makers can operate there also.

Only the Mexican exchange segments its market by the liquidity of its stocks. On the
Sentra, stocks can be traded continuously, by call auction, or in a combination of the
two methods. All types of stocks and all types of orders can be traded continuously.
With limited orders, the most liquid stocks could also be traded in one or several call
auctions per day. The number of call auctions is determined by the Mexican ex-
change. Mixed trading is the procedure in which stocks can be traded continuously or
in call auctions. However, in most cases call auctions are used to determine the price
of a new stock, to reopen the negotiation of a stock, or to determine the closing price.
As regards country of origin, the exchanges of Sao Paulo, Santiago, Mexico, and
Lima also classify their stocks in National and International Segments. However, the
trading mechanism is the same for both classes of stocks.

The exchanges of Sao Paulo and Santiago also classify their stocks according to cor-
porate governance practices. The Bovespa (the market index of the Sao Paulo stock
exchange) has three sections: Level 1, Level 2, and Novo Mercado (New Market).^^

The main requirements of Companhias Nivel 1 include the maintenance of a free-float of at least
25% of capital, a quarterly report of consolidated figures and special audit revision, the disclosure of
shareholder agreements and stock option programs. To be classified as a Companhia Nivel 2, in addi-
tion to the obligations of Nivel 1 the company and its controlling shareholders must adopt and observe
a much broader range of corporate governance practices and minority shareholder rights. Among other
criteria for listing in Level 2, the annual balance sheet must be made available in accordance with U.S.
GAAP or IAS. Growth stocks are listed in the Novo Mercado. The main characteristic of this segment
is that non-voting shares are not issued.

61
 o o o o o o o .
2 Z Z Z Z Z Z

I >l o o o o o o o
z z z z z z zX
(D

o
X X X X X m ml
o

o
XX X X X X X X 00 00.
o

o
X X X X X X X X X O) Ol
o

o
X X X X X X X 1^ "^ T5 ?^ .
o ^ _^ 1
^ 2 a
o S O P
XX X m iq
o n ^ (U •S 2
JS o
'Si
>> r5 <D ?^
H 8 S
o o
x X X X X X X XX 00 00.
o
2 t- = -S
>S • C/3 U

o
XX X X lO l^J cr 2:
o 8 •- « 3
as-
T3 «J
00

XX X X m ^J
o -^ I I I
o| u c
••S 2
T3 -iii
g w .§ (U li t'S

o C (U
XX X X X X X X 00 00^
o
6 6 .;=i eg
=3 e J3 9-

o if o -d
5b S «j S ^
XX XX r^ f\l « 13
o
•S .S =3
in
•s 1 ^ i3 S^ « o i^ "S 8
0) ^ V- o «3 ^
D -S ^

o
11 o

1^5 <5 o
O "Sb ^
g o o

o III
- ^ .-^ iZ £ o P B
'B
o
®
w
c si 11 11
^ a-
0^ ^ .S

H 2 : J < C O C O C O < I J J X C Q
o o
0- zUcu
z[ P 6
- 2
< 00 00 •ll ^ 1^^
00 < W X ffi PQ H

62
Table 3.7: Segments of the Stock Markets

Capitalization Order Size Liquidity ^^^^,^'^^1^ Origin "^^^^

Buenos Aires Merval (large) Large 6

General (me- K/,^^:..^oor«oii (0.6)
dium/small) [Link]&small
New Pro-
New Projects
jects (high
(high growth) growth)
San Paulo Large Level 1 International 6
Mediunn&sniiall Level 2 (0,6)
New Market
Stock mar-
Santiago International
Large ket
Emerging
(0,5)
Medium&small Firms
Colombia Large 2
Medium&small (0.2)
Continu-
Mexico International 6
Large ously
Medium&small Call Auction (0.6)
Mixed
Lima Large International 3
Medium&small (0.3)
Caracas Large 2
Medium&small (0.2)

France Premier Large&mediu

High 9
Marche m
Second
Small Medium (0.9)
Marche
Nouveau Mar- Nouveau
Low
che Marche
Frankfurt Official Large High 10
SMAX Medium Medium (1)
Neuer Markt Small Low Neuer Markt
London Main Market w i .i- u
International 10
(large stocks) ^^^'^^S^ ^^'9^
Main Market , « ..
(medium Large&med.u ^^^.^^ (1)
stocks) ^
AIM Small Low
Points are obtained by adding the number of market segments. To compute the note, the number of
points is divided by 10 (maximal number of market segments). The information was collected from
web-pages of the stock exchanges.

Growth firms are also listed in the Santiago Stock Exchange's Novo Mercado. Mar-
ket-makers support the trading of the negotiated stocks in the new markets of Sao
Paulo and Santiago. To be quoted in this segment, more rigid corporate rules must be

63
fulfilled. These rules increase shareholders' rights and enhance the quality of informa-
tion commonly provided by companies.

Developed markets classify their orders by size^^ into small, medium, and large, and a
specific trading procedure is used for each order size. For the LAEM see Table 3.8. In
all Latin American stock markets, small orders (also called "lot orders") are traded to-
gether with medium sized orders, as in the Paris Bourse. In the other developed mar-
kets, special mechanisms exist for each order size (see Demarchi and Foucault
(1998)). In Latin America the small and medium sized orders can be placed and exe-
cuted in their ETS, and in Lima also on the floor. In Buenos Aires, Sao Paulo, and
Santiago, they can also be traded on the floor by a call auction if the order belongs to
a liquid stock. In the Mexican exchange, orders of liquid stocks can also be traded by
auction within the limit order book.

Table 3.8. Trading Mechanism for Order Size

Buenos Aires Large Call Auction

Medium & small Central limit order book and sometimes call auction
San Paulo Large Special Auction Method
Medium & small Central limit order book and sometimes call auction
Santiago Large Call Auction
Medium & small Central limit order book and sometimes call auction
Colombia Large Call Auction
Medium & small Central limit order book
Mexico Large Special module within the central order book
Central order book and/or call auction within limit order
Medium &small book
Lima Large
Medium &small Central limit order book and sometimes call auction
Caracas Large Special module within the central order book
Medium &small Central limit order book

France Large &medium Principal trading or limit order book

Principal trading within limit order book or limit order
Small book
Frankfurt Large Limit order book or "Vermittlungs- und Suchmarkt"
Medium Limit order book and/or principal trading
Small Call market and/or principal trading
London Very large Principal trading
Large &medium Principal trading or limit order book
Small Retail service providers
The information was collected from web•pages of the stock exchanges and from Demarchi and Foucault
(1998).

^^ Size is defined in terms of the number of shares posted by a firm or in terms of its the monetary
value.

64
Trades of block orders require different mechanisms. Because the depth of the Hmit
order book can be insufficient to place large orders (also called "block orders")
quickly without impacting on the stock price, block orders can be split into smaller
orders, which can be executed against the prices in the limit order book. Thus, if quick
trading is very important, traders might prefer to deal with an intermediary who is ca-
pable of providing immediacy.

Most of the Latin American stock exchanges have been in the process of introducing a
special mechanism to trade block orders similar to those in place at the exchanges of
Continental Europe. Large orders can be traded outside the central order book by a
member acting as a principal. The order-driven mechanisms of the exchanges can
usually switch to a quote-driven mode, and sometimes intermediaries support the
transaction by crossing the orders of their clients. In Buenos Aires, Sao Paulo, and
Santiago a special auction procedure is defined. For example, in Santiago, where large
orders can be traded, three auctions are performed daily. In the Bogota, Mexico, and
Caracas stock exchanges, block trades are performed in their ETS using a special pro-
cedure.

[Link] Electronic Trading Systems^^

The applications of new trading technologies directly affect the market architecture,
which in turn influences market quality, that is, market characteristics such as liquid-
ity, trading cost, price efficiency, and resistance to shocks. The international evidence
shows that the trading cost has considerably fallen, and one of the drivers of that fall
appears to be the automation driven disintermediation of trading (Domowitz and Steil
(1999), Domowitz et al. (2001)). Furthermore, Domowitz and Steil (2001) demon-
strate that the use of new technologies in trading processes have eliminated distance
costs^^ and brokerage costs,*^^ or at least reduced them to an electronic credit risk con-
trol function.^^ They also have found that reductions in trading costs increases turn-
over and directly causes a decline in the cost of equity.

The term "Electronic Trading Systems" has been used in many ways. Here it refers to the automation
of trade execution (contrary to e-commerce).
^* The location of participating traders does not play a role any longer. They have direct access to the
electronic trading mechanisms wherever they may be located geographically.
^^ The intermediation functions of brokers diminished. Some functions have been automated and there-
fore the cost of trading has decreased.
^^ The system tries to ensure that the investor has the requisite funds to buy or sell securities.

65
Electronic mechanisms might not only enable more efficient markets, but they can
also hinder them (Allen et al. (2002)) and increase their risk. Trading on an electronic
system exposes participants to risks associated with the failure of the system or one of
its components. If a component fails, traders might not be able to execute, modify, or
cancel their orders, or enter a new one. Furthermore, the failure of the system or a
component might cause the loss of order priority or even of complete orders.

It is particularly interesting to compare the trading systems used in Latin America and
investigate whether their differences cause additional trading costs. To do this, in the
next section we compare the functions of Latin American electronic trading systems,
then their transparency, and finally their use of call auctions. But before pursuing this
further, it is instructive to consider a brief history of the development of the electronic
trading systems in Latin America.

Introduction of Electronic Trading Systems in Latin America

The use of ETS is not new in the Latin American stock exchanges. The Sao Paulo
Stock Exchange was the first in Latin America to implement an ETS. In 1990 they
started to carry out operations through the Computer Assisted Trading System
(CATS) of the Toronto Exchange, which operates simultaneously with the open out-
cry system. The Mexican Stock Exchange followed with the incorporation of CATS,
and two years later the Caracas Stock Exchange implemented the electronic system of
the Vancouver Stock Exchange. Others, including the Santiago Stock Exchange in
1993, adopted tandem computerized platforms. However, these systems are no longer
in use.

Nowadays each stock exchange in Latin America uses a different ETS. Buenos Aires,
Santiago, and Mexico trade electronically with a system that each developed on its
own (see Table 2.3). The other markets use versions of systems developed by other
exchanges. In 1995 the Lima Stock Exchange launched a system called Elex, which
was developed by Effectinvest-Wien. In 1997 the Sao Paulo Exchange implemented
their Mega Bolsa, which is a version of the NSC from the Paris Bourse. The stock ex-
change of Bogota also uses a version of the NSC, while the Caracas Stock Exchange
uses the electronic trading system SIBE from the Madrid Stock Exchange.

66
Functions of Electronic Trading Systems

In order to identify differences in the electronic trading systems of the LAEM that
may affect transaction costs, some of their most important characteristics are pre-
sented in Table 2.5. The features are divided into three groups. The first presents gen-
eral peculiarities of electronic trading systems. In this group the electronic trading
mechanism of these markets share similarities. First, all of them are order-matching
systems, which operate as order-driven markets.^"^ Second, in all electronic trading
systems priority is given to the price before time is taken into account. Third, there is
continuous trading in all the electronic systems of the selected markets. Fourth, the
electronic systems offer interfaces to in-house systems or to third products. And fifth,
other securities, together with stocks, can also be traded. The electronic mechanisms
also have some different general characteristics. The flexibility of the electronic sys-
tems to trade in integrated stock markets varies across the LAEM. The ETS of Cara-
cas is the only market in Latin America that allows simultaneous trading of a stock in
different currencies. Furthermore, the electronic systems of Sao Paulo, Bogota, Mex-
ico, Lima, and Caracas can be used with other exchanges at the same time. As men-
tioned above, the failure of the ETS is a potential source of risk. To reduce this risk,
the exchanges of developed markets have also installed outside backups in other loca-
tions, where complete trading information is also saved. Unfortunately, only the ex-
changes in Mexico, Lima, and Caracas have done this so far.

The second group in Table 3.9 presents some important characteristics of electronic
systems that facilitate trading. Here the ETS have some analogies. All ETS give dif-
ferent levels of access to users. In all ETS several types of orders can be traded; how-
ever, the types vary among the markets. Another similarity of all ETS is that they use
Multi-Visualization. More than one window can be opened so as to provide access to
different products at the same time or to display results in different forms (numeri-
cally, in charts, etc.). Despite these similarities, the facilities available to traders differ
significantly from one another. Surprisingly, the traders cannot cancel their placed or-
ders in some ETS. Only in two ETS is it possible for the user to define search criteria;

Through computer terminals, the brokerage firms input bids and offers into the system. Then the or-
ders are automatically executed according to price and time priority.

67
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69
not all systems can compute quotes using different methods or compute indexes auto-
matically and in real time. Finally, the integration of internet brokerage services also
varies.

The last group of characteristics in Table 3.9 refers to the facilities that are available
for actualizing information and tools for evaluating stocks. All electronic trading sys-
tems in Latin America update in real time the information that they themselves gener-
ate and that they receive from external sources. Furthermore, all of them also provide
access to historical data. However, only the ETS in the Santiago Stock Exchange of-
fers a broad array of technical and statistical functions to analyze stocks and other
traded instruments.

Transparency
Transparency is also an important component of the ETS since it also plays a critical
role in the price determination (Demarchi and Foucault (1998)). Transparency is the
degree to which information on securities quotes, transaction prices, and transaction
volume is made publicly available. Transparency is usually divided into pre-trade and
post-trade information. Pre-trade information includes information on the orders that
are currently standing in the trading system and on prices at which incoming orders
can be executed. On the other hand, post-trade information is the information on the
details of past transactions, such as transaction price, transaction size, and the identity
of parties involved in the transaction.

Panel A of Table 3.10 presents the information available during the pre-trade phase in
the ETS of the seven Latin American stock markets and four developed markets. As
in the trading systems of developed markets, member firms get more pre-trade infor-
mation than public investors in the ETS in the Latin America stock exchanges. Mem-
ber firms can obtain the entire limit order book, and in the ETS of Brazil, Colombia,
Mexico, and Venezuela they know the identity of the traders placing orders. Pre-trade
information made available by the market organizers to investors also varies across
markets. As in Xetra, in the ETS of Buenos Aires, Santiago, Mexico, and Peru public
investors only know the best bid and ask prices. As in SETS, none of the electronic
trading systems of the LAEM completely display all limit orders. Similar to the NSC,
in Sao Paulo, Colombia, and Caracas public investors have access to five best bid and

70
ask prices. Furthermore, in the ETS of Argentina, Mexico, and Venezuela traders can
submit hidden orders in the same way as in Paris.^^

It is common that order-driven markets open the daily trading operations with a call
auction, usually known as a pre-trading session. Organizers of the pre-trading session
can provide information on the submitted orders to the market and on the Indicative
Equilibrium Price (lEP).^^ As in the trading systems of London and Paris, in the trad-
ing systems of Sao Paulo, Santiago, Colombia, and Caracas the order book is open.
By contrast, the order book of Buenos Aires, Lima, and Frankfurt is closed. An lEP is
published in Sao Paulo, Colombia, Bogota, Paris, and Frankfurt, while in Buenos Ai-
res, Santiago, Lima, and London it is not.^^

Post-trade information of the analyzed ETS is shown in Panel B of Table 3.10. Simi-
lar to developed markets, all Latin American trading systems immediately publish the
trades of small and medium orders. The information of large trades is published with a
delay that varies from 48 hours (in Sao Paulo, Santiago, Mexico, and Caracas or
Paris) to 72 hours (in Buenos Aires, Bogota, and Lima).

Use of Call Auction

Call markets are commonly used in developed countries because of the uncertainty in
the valuation of assets generated by the overnight trade interruption. With call auc-
tions the information is aggregated more efficiently. This facilitates price discovery in
subsequent continuous trading. Therefore, informational efficiency might increase be-
cause overnight uncertainty diminishes (see Demarchi and Foucault (1998)).

Call auctions in Latin American stock markets are not as commonly used to open and
closed trade sessions of the ETS market as in the developed markets (see Table 3.11).
The Chilean, Colombian, and Mexican ETS do not use an auction to open the market.

^^ Harris (1996) finds that hidden orders must be used more frequently in volatile markets, but also that
the fraction of hidden orders and the size of the hidden portion increase with the volatility.
^ lEP is the price at which an order would be realized if opening occurred at that instant.
^^ In the Mexican Stock Exchange there is not an opening phase.

71
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74
These systems use the closing price as the opening price. The Sinac of the Buenos Ai-
res Stock Exchange is the only system that does not have a module to organize an
auction in order to close its trading session. In Latin America only the ETS of Sao
Paulo and Mexico use intraday call auctions integrated with a continuous order-driven
market, such as Xetra.

Table 3.11: Use of Call Auctions

Market Opening Market Closing Intraday Points Note

Sinac X 1 0,33
Mega Bolsa X X 2 0,67
Telepregon X 1 0,33
Electronic X 1 0,33
Sentra X X 2 0,67
Elex X X 2 0,67
Sibe X X 2 0,67

NSC X X 2 0,67
Xetra X X X 3 1
Sets X 1 0,33
Points are obtained by adding the number of call auctions used by each electronic system. To com-
pute the note, the number of points is divided by 3 (maximum number of points an electronic trading
system can get). The information was collected from web-pages of the stock exchanges and from
Demarchi and Foucault (1998).

[Link] Trading System Index

The interest in trading systems grew quickly due to its influence on price formation.
Stock trading systems in each of the analyzed exchanges showed some similarities
and differences. It is important to identify these because of their impact on the price
discovery process, that is, on transaction costs and risk. The best way to grasp the
quality of the trading systems and to compare them is to determine a quantitative
measure, such as an index. Hence, the TS-Index is computed here for each stock ex-
change analyzed.

The TS-Index is computed by averaging the scores of market segmentation and the
scores on the electronic trading system. Before this computation is performed, the
scores of market segmentation and electronic trading system are calculated by averag-
ing the components of each (see Figure 3.5). For the score of market segmentation
two components (types of stock orders and segments of the stock market) are aver-

75
aged, while for electronic trading system three (functions of the electronic trading sys-
tems, the use of call auctions, and information transparency) are averaged. The score
of each component is given in a corresponding table, where it is also specified how
the rating was computed. The components of the index are the most often cited in the
literature or in the trading system descriptions of the stock exchanges. The way the
components are aggregated does not have a theoretical or empirical foundation, but
the results of the TS-Index are in accordance with the implicit trading costs of Do-
mowitz et al. (2000).^^

Table 3.12: TS-Index

Market Segmentation Electronic'rrading System TS-

Orders Segmentation Note Func- Index
tions Auctions Transparency Note

Buenos Aires 0,70 0,6 0,65 0,67 0,33 0,38 0,46 0,56
Sao Paulo 0,80 0,6 0,70 0,78 0,67 0,85 0,76 0,73
Santiago 0,50 0,5 0,50 0,78 0,33 0,62 0,58 0,54
Colombia 0,50 0,2 0,35 0,50 0,33 0,62 0,48 0,42
Mexican 0,80 0,6 0,70 0,78 0,67 0,69 0,71 0,71
Lima 0,50 0,3 0,40 0.78 0,67 0,31 0,58 0.49
Caracas 0,70 0,2 0,45 0,89 0,67 0,92 0,83 0,64

Paris 0,90 0,9 0,90 0,83 0,67 0,92 0,81 0,85

Frankfurt 0,80 1 0,90 0,89 1 0,62 0,83 0,87
London 0,50 1 0,75 0,33 0,69 0,51 0,63
New York
Nasdaq
The TS-Index is an average of the notes of market segmentation and electronic trading system. Both
notes are computed by averaging their components. The note of each component (orders, segments,
functions, auctions, and transparency) are from their tables above.

Table 3.12 shows the TS-Index and its components for the analyzed markets. Among
the Latin American trading systems, a significant heterogeneity can be detected. Sao
Paulo, Mexico, and Caracas have the highest TS-Index, and Colombia and Lima the
lowest, while Buenos Aires and Santiago are in the middle. Compared to the trading
systems of developed markets, the seven Latin American systems have index ratings
below those of the analyzed developed markets, except London. Trading segmenta-
tion shows the greatest differences among the Latin American and developed trading
systems. The main source of this might be the lower volume and the smaller number
of stocks traded in the Latin American exchanges. Furthermore, the electronic trading

^* To my knowledge, no TS-Index was developed in any previous investigation.

76
systems of the Latin American exchanges do not offer certain functions that are com-
mon in the developed markets. The reduced alternatives for trading and the absence of
some functions of the ETS might increase trading cost, which in turn affects liquidity
and the cost of capital in Latin America. If we compare these results with the implicit
costs of Table 3.1, the results are meaningful.

3.3.9 Custody, Clearing, and Settlement Process

The clearing and settlement systems of stocks are an important component of the in-
frastructure of financial markets. This phase of the trading process begins after the
brokers execute the orders. Although this phase seems to be administrative, problems
can arise if one of the two parties does not fulfill the contract. A financial or opera-
tional problem in the clearing and settlement process could give rise to liquidity pres-
sures or credit losses for other participants. Therefore, an additional risk can be gener-
ated for which the investors may demand a higher premium. When the clearing and
settlement process is riskier in the Latin American markets, the systems used, the le-
gal framework, and the payment systems are weaker. To quantify the risk of the cus-
tody, clearing, and settlement process in the LAEM and to compare them to some de-
veloped markets, an index is computed.

The Custody, Clearing, and Settlement Index (CCS-Index) is made up of information

on each of its three components (see Figure 3.4). The first central element analyzed is
the Central Securities Depository registries. The CSDs are important because, before a
stock can be traded on an exchange and before its ownership can be transmitted from
one owner to another, the stock must be stored or registered in a CSDs. The clearing
and the settlement are the second and third central elements, respectively. They are
two relevant steps that should be followed in order to achieve an efficient and safe
transfer of value (stock vs. payment) between the counterparts. In the next three sub-
sections, the three elements of the CCS-Index are discussed, and in the final subsec-
tion the index is calculated and discussed.

[Link] Custody

A central element of a clearing and settlement system is its CSDs (Guadamillas and
Keppler (2001)). CSDs are important since they enable smoother and more efficient
operations of book entry systems. Experience indicates that several features and func-

77
tions of a CSDs influence efficiency. First, the ownership structure is important due to
the pressure management can place on parties in order to avoid default on transac-
tions. Second, the additional services provided by the CSDs. And third, the form in
which records of ownership are held influences the associated risks related to lost, sto-
len, or altered documents. We now turn to a discussion of each of these features and at
the same time present the CSDs of Latin America and some developed markets.

The ownership structure of the Latin American CSDs is similar to those of developed
markets. In the LAEM and in most developed countries, CSDs are private firms con-
stituted as self-regulatory organizations, which are overseen by the market regulator.
CSDs have a close relation to the stock exchange because it is generally considered
unacceptable for a stock exchange to cancel a transaction when, for example, a buyer
or a seller could not meet his obligations. Although the direct participation of the
Latin American stock exchanges in their CSDs is not as high as in developed markets,
exchanges have a considerable influence in an indirect way. Usually the members of
the stock exchanges are also shareholders in the CSDs (see Table 3.13).

Similar to the services provided by the CSDs in developed markets, CSDs in most
Latin American countries provide additional services, such as securities administra-
tion (cash dividends, interest payments, redemption, capitalization, exchanges, con-
versions and splits, and subscriptions) and issuer services (accounting registry of
stockholders, corporate actions such as cash dividend payments, capitalization, sub-
scriptions, exchanges, splits, etc., and updating rights).

The mechanism for recording ownership of a CSDs influences the quality of the book
entry systems. There are primarily two mechanisms for registering ownership. The
first makes use of paper-based instruments with the physical delivery of certificates
between counterparties, while the second system relies on computer-based transfer
mechanisms in which records of ownership are held in so-called book entry form.
Nowadays, most of the CSDs use computer-based mechanisms since they are more
efficient and safer inasmuch as they eliminate the movement of paper. Thus, associ-
ated risks related to lost, stolen, or altered documents are reduced. In turn, computer-
based mechanisms can be subdivided in immobilized and dematerialized systems. In
an immobilized system, physical certificates are held in secure vaults and provide the
essential support for book entry maintained ownership positions of market partici-

78
pants. In a dematerialized system, physical securities do not exist as they are replaced
by book entry records.

Table 3.13: Central Securities Depositories-Registries Shareholders

Stock Ex- Brokerage pj^ancial Central Bank Issuers Others

change Firms institutions

Merval (Buenos Aires) 49.98 50,02037*

CBLC (Sao Paulo)
DVC (Santiago) 23,00 1,00 76,00
Deceval (Bogota)
Indeval (Mexico) 1,79 57,14 39,29 1,79
Cavali (Lima) 20,00 60,42 10,41 9,17
C W (Caracas) 26,41 3,30 52,88 17,41

Euroclear (Paris)
Clearstream (Frankfurt) 100,00
NSCC (NYSE)
* 49,98 is held by the Mercado de Valores de Buenos Aires and the rest by the other exchanges of
Argentina.
The information was collected from web-pages of the stock exchanges.

The current state of ownership stock records varies across Latin American CSDs.^^
First, all CSDs except the Chilean use only computer-based mechanisms. The Chilean
CSDs is the only one in Latin America where more than 10% of the physical shares
are held in the form of paper. In the other six Latin American CSDs—just as in Lon-
don, Frankfurt, and New York—most of the stocks are dematerialized, and a small
percentage is held as physical stock certificates.^^ For identification of the stocks, all
the CSDs use the internationally applied code system IS IN, except for Cajval and
DCV. The use of a common code by all CSDs is important since it facilitates the iden-
tification of a stock and the reduction of transaction risk.

This information is taken from the Centre for Latin American Monetary Studies, 2000, Yellow Book
for Argentina, Chile, and Peru, as well as from the web-pages of the ten stock exchanges and their
CSDs.
^® Physical certificates are normally issued for special corporate events. In very few cases, there still are
physical stocks that are stored in vaults.

79
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80
According to the international trend, six of the Latin American markets (all except
Santiago) have an electronic system for deposits and transfers. Each depositor has ac-
cess to the automated operations via remote terminals. The users can electronically
manage their securities, operate and control trades executed on the stock market or in
over-the-counter trading. The systems also provide modules for the electronic transfer
of securities, so that brokers can record, confirm, look up, and settle trades directly.
DvP-Transfers, checking of trade lines, credit and trading accounts, money transfers
between the CSDs, and the central bank payment systems are also automated proc-
esses. Only CBLC (Brazil) and Indeval (Mexico) have created an electronic system to
arrange securities loans.^^

[Link] Clearing Process

The first step of the third phase is the clearance of trade. Assuring that safety, sound-
ness, certainty, and efficiency are achieved at an acceptable level of cost to all partici-
pants, clearing is an important part of the financial infrastructure of a nation.^^ This
step includes trade capture, matching, confirmation, comparison and affirmation
mechanisms, and the calculation of settlement obligations (Guadamillas and Keppler
(2001)). The obligations of the direct market participants (brokers, promoters, special-
ists, etc.) to deliver securities and funds are determined in this step. There are two
methods for computing settlement obligations. The selection of one of them is very
important because of their impact on the efficiency and risk exposure of the system.
Their weaknesses and strengths are the result of a trade-off between liquidity require-
ments and risk mitigation (for a discussion see Guadamillas and Keppler (2001)).
Both methods are discussed below.

The calculation of settlement obligations is the most important task in this step and
can be effected on a net or a gross basis. Netting can be done bilaterally or multilater-
ally. By netting on bilateral basis the credits and debits are offset pair by pair. In mul-
tilateral netting mechanisms, an agent's transactions (both buys and sells) are com-
bined at the end of the clearing cycle, and only the net amount is settled. As a result.

^' For complete descriptions of their automated processes, see the web-pages of the relevant CSDs.
^^ However, settlement and the other components of the trading architecture are also important and with
the analysis in this and following chapters cannot be answered which element is more important. While
this question would worth pursuing in further research, the goal of this chapter is solely to construct
indexes with the characteristics identified in the literature as the most important. The development of

81
the settlement amount is reduced. So a smaller amount of intraday liquidity will be
needed. However, the interdependence of the different transactions increases thereby,
and thus also the domino effects of a failing delivery. So there is a trade-off between
costs and systematic risk. Due to its characteristics, multilateral netting is the most
common used system.

The other alternative for calculating the settlement obligations are gross settlement
mechanisms. These systems compute each transaction separately. Such methods have
the advantage of reducing the interdependence problem of netting. Thus, if transac-
tions are settled on a gross basis, credit and liquidity risk would diminish. However,
the use of these systems gives rise to several costs (Niemeyer (2001)). First, the total
cost will increase as a consequence of a higher amount and number of transfers. Sec-
ond, the costs of capital to which participants are exposed will rise due to the greater
amount of capital needed to handle imbalances. Third, the higher costs might limit the
intraday trading, causing a lower market liquidity; and fourth, payment problems may
become more frequent as a consequence of the disadvantages mentioned above.

The computational method used to determine the net volume and value of stocks and
cash to be exchanged between counterparties varies among the CSDs. First, the cash
credits and debits to be transferred are computed on a multilateral netting basis in all
the CSDs. By contrast, the netting variants for stocks vary across markets. Like in
Euroclear and NSCC, the CSDs of Buenos Aires, Mexico, and Caracas effect their
netting on a multilateral basis, while only in Santiago it is done on a bilateral basis.
Similar to Clearstream, the CSDs of Brazil, Colombia, and Peru compute the stock net
volume and value of stocks on a gross basis.

[Link] Settlement Procedure

The last step of the third phase is the settlement. It involves the discharge of settle-
ment obligations through the final transfer of funds from the buyer to the seller, and
the final transfer of securities from the seller to the buyer. Three aspects, which will
be discussed below, are very important in the settlement phase: Delivery versus Pay-
ment, settlement assurance, and the time a trade takes to be settled.

indexes is a practical and implementable assessment methodology encompassing key issues that have

82
Table 3.15: Clearing and Settlement

Clearing Settlement
Cash Net- Stock Net- Transfer Transfer Settlement Foreign
ting ting of Stocks of Funds1 DvP Model Time Investors

Buenos Aires Multilateral Multilateral BE NPS Model III T+3 Custodian

Gross BE NPS Model 11 T+3 Custodian
Santiago Multilateral Bilateral Ph/BE NPS Model III T+2 Custodian
Colombia Multilateral Gross Model li&l T+3
Mexico Multilateral Multilateral BE NPS Model III T+2 Direct
Lima Multilateral Gross BE Bank Model II T+3 Custodian
Caracas Multilateral Multilateral Model Ml T+3

Paris Multilateral Multilateral BE NPS Model III T+3

Beetween
Frankfurt Multilateral Gross BE NPS T+2
Model ll&l
NYSE Multilateral Multilateral BE NPS Model III T+3
Ph stands for Physical, BE for Book Entry, and NPS for National Payment System. The information
was recollected from web-pages of the stock exchanges.

Delivery versus Payment

Settlement can be carried out using a variety of procedures, but the most common is
Delivery versus Payment (DvP). The DvP procedure is important for security transac-
tions because it can help to mitigate counterparty risk, which is one of the most im-
portant in the settlement process. A reduction of this risk can be achieved by ensuring
that sellers give up their securities if, and only if, they receive full payment and vice
versa.

According to Guadamillas and Keppler (2001), a DvP transaction contains three es-
sential elements: a good and irrevocable delivery of securities, a final and irrevocable
delivery of funds, and a simultaneous exchange. The transfer of stocks can be carried
out physically or using the book entry method. The latter is usually employed in de-
veloped as well as in Latin American markets. On the other hand, cash can be trans-
ferred electronically through accounts within the national payment system or through
a bank that assumes the role of cash settler. The first alternative is employed in Ar-
gentina, Brazil, Chile, and Mexico, while the second is usual in Colombia, Peru, and
Venezuela (see Table 3.15).

an impact on the quality of the treading architecture of a country.

83
To the theoretical aspects of DvP in depth, the Bank for International Settlements
(BIS) has identified three different basic models for its application. In Model I, the
system settles instructions to transfer stocks against simultaneous payment on a trade-
by-trade basis throughout the day. In Model II, stocks are transferred and settled on a
trade-for-trade basis throughout the processing cycle, while funds transfers are settled
on a net basis at the end of the processing cycle. Finally, in Model III, systems settle
instructions to transfer both funds and securities on a net basis, and the transfer of
funds and securities occur at the end of the processing cycles.

Given the market conditions of the LAEM, the selection of one of the models is not
straightforward. Model I, on the one hand, reduces the potential for settlement failure
by reducing the progressive build-up of credit exposure between participants and on
the other hand, it requires a critical mass of marketable securities and system-wide li-
quidity for its efficient operation (Guadamillas and Keppler (2001)). The liquidity
needs may represent a restriction to the implementation of this models in the LAEM.
Model in reduces the volume and value of the final transfers; however, it can increase
the systemic risk.^^ Under these considerations, Model III with periodically settlement
during the day would be an interesting alternative, which could be analyzed in further
research.

The DvP-systems applied in the Latin American stock exchanges must be distin-
guished. The stock exchanges of Buenos Aires, Santiago, Mexico, and Caracas settle
funds and stocks using Model III, as in the Paris Bourse and the NYSE. Sao Paulo and
Lima use Model II, and only Bogota and Frankfurt apply a mechanism intermediate
between Models I and II.

Settlement Time
Another important aspect of settlement is the time necessary for a trade to be settled.
It is widely recognized that the longer it takes to settle a securities trade, the higher the
risk that the settlement may not be realized. Consequently, a chief goal in the design
of settlement systems is to shorten the time between trade date and settlement date.^"^
The duration of the settlement cycle in developed and Latin American exchanges var-

^^ There are some mechanisms such a novation (see below) to reduce the systemic risk, but they require
a legal environment that support them.
''^ However, shortening the settlement time generates some disadvantages. For example, the number of
trades that fail to settle may increase (see Guadamillas and Keppler (2001)).

84
ies between two and three days after the trade date. As in Frankfurt, the settlement of
domestic trades in Santiago and Mexico is effected within 48 hours (T+2), while it
takes 72 hours (T+3) in other exchanges. Therefore, the G30's suggestion that trade
settlement should occur by T+3 or less is fulfilled by the LAEM.

Settlement Assurance
Due to the risks that arise in this step, settlement assurance is an important concept
and can be understood as the arrangements by which a system tries to remove coun-
terparty risk (principal, replacement cost, and liquidity risk) from its participants
(Guadamillas and Keppler (2001)).

There are different ways to achieve settlement assurance. In case of default, fraud, or
negligence on the part of a member, the DvP mechanism reduces only principal risk.
Therefore, a CSDs has to implement additional preventive measures. To do so, CSDs
usually take the stocks from the member who defaults and sells them inmiediately on
the open market. But the counterpart or the CSDs (by novation, see below) will
thereby be exposed to market risk. To mitigate the risk, CSDs have several alterna-
tives or a combination of them: (1) the CSDs may liquidate the securities that the de-
faulter may have on deposit at the Custody Institution. (2) If the generated revenues of
the liquidation are insufficient, CSDs in most countries maintain a guarantee fund,
which can be financed with a percentage of CSDs-profits and/or with member contri-
butions.^^ (3) CSDs also demand collateral to reduce market risk. All members are re-
quired to buy shares of the CSDs and pledge them, for example, in favor of an insur-
ance company and/or of deposit provisions. If a member fails, the CSDs would try to
sell the collateral to cover any shortfall. (4) Most of the CSDs operate stock loans fa-
cilities that are used mainly to reduce the impact of shortfalls in the settlement proc-
ess. And (5) some CSDs stipulate operational limits, which are based on an analysis
of the member's financial and economic standing.

In addition to the mechanisms mentioned above to reduce risk, novation is a very im-
portant mechanism. In systems that include novation, the original trade between two
counterparties is split in two separate trades (Bemanke (1990)). The clearinghouse

^^ There are only two funds in Argentina: The first, the Guarantee Fund, is financed with 50% of the
CSDs profits and is used if a member does not fulfill his obligations. The second, the Special Guaran-
tee Fund, is financed with the contributions of members and is used to reimburse investors in case of
gross stockbroker negligence or fraud.

85
becomes an official party to every trade, substituting itself as a seller to every buyer
and a buyer to every seller. Therefore, counterparties' exposures to one another are
extinguished and replaced by exposures to a central counterparty. This facilitates mul-
tilateral netting and provides the basis for counterparty risk guarantees. However,
novation causes a default risk to the CSDs. Therefore, novation should be imple-
mented with a combination of the preventive measures explained before.

Table 3.16 shows a list of different settlement assurance procedures used in the se-
lected stock exchanges.^^ According to Table 2.12, CSDs can be subdivided into three
groups. The first group is Merval with Euroclear, Clearstream, and NSCC, where set-
tlement is guaranteed (i.e., novation is implemented) and the mechanisms for reducing
market risk are similar. The second group is integrated by CBLC and Indeval. In order
to diminish settlement risk, these CSDs have implemented a guarantee fund, a collat-
eral plan, and a money and stock lending mechanism. Finally, the third group is com-
posed of DVC and Cavali, where buy-ins and sell-outs have been implemented, but a
guarantee fund is still under construction and securities lending is generally not regu-
lated, even though there are specific sets of rules for short sales and for the lending of
shares. In these CSDs, if one of the counterparties defaults, that counterparty can be
punished, which may involve the cancellation of his right to trade in the exchange.
For resolutions, such penalty can be maintained until the affected member receives the
agreed stocks or cash plus interests.^^

[Link] Custody, Clearing, and Settlement Index

As discussed above, the systems of clearing and settlement are important components
of the financial market's infrastructure because they could give rise to liquidity pres-
sures or credit losses for market participants. Therefore, it is necessary to have an in-
dex that compares the clearing and settlement systems used in the LAEM with those
of certain developed countries.

Table 3.17 presents the CCS-Index of the LAEM and three developed markets. It in-
cludes the three components discussed in the previous section: (1) the CSDs, (2)
clearance of stock trade, and (3) settlement. For each of these components a rating is

^^ The stock exchanges of Colombia and Caracas have not been included here because it was not possi-
ble to find enough information on their settlement assurance procedures.
^^ See the Yellow book of Chile and Peru.

86
calculated based on information on some variables7^ In Table 3.17 the variables use
for each component can be seen. Also in the lower portion of Table 3.17, an explana-
tion is given of how the ratings of the three components are calculated.^^ Then the
CCS-Index for each stock market is computed by averaging the notes of each element.

The results are conclusive: the custody, clearing, and settlement process varies across
the CSDs of developed and Latin American countries. According to the CCS-Index,
the custody, clearing, and settlement process is safest in New York and Mexico.^^
Then follow Paris, Frankfurt, Buenos Aires and Sao Paulo. However, the reasons for
the lower CCS-Index in these financial centers are different. Buenos Aires should en-
force the functions of its CSDs, Sao Paulo should improve the clearing and settlement
process, in Paris the score on settlement is lower than in the other developed markets.

Table 3.16: Settlement Assurance

Novation Q " ' - * - Co..[Link]. ^^^^^ Note

Merval (Buenos Aires) X X X X 2

CBLC (Sao Paulo) X X 1
DVC (Santiago) X X* 0
Deceval (Bogota)
Indeval (Mexico) X X X 1
Cavali(Lima) X X** 0
CW (Caracas)

Euroclear (Paris) X X X X 2
Clearstream (Frankfurt) X X X X 2
NSCC(NYSE) X X X X 2
The Note is determined by assigning 2 if novation exists; 1 if at least two elements (Guarantee Fund,
Collateral or Stock/Money lending) exist to guarantee settlement, and 0 otherwise. The information
Was collected from web-pages of the stock exchanges.
* A Negotiation System does not exist and securities lending is generally not regulated. There is a
specific set of rules for short sales and for lending of shares.
** A Negotiation System does not exist.

^^ The rating of a CSDs does not include variables of ownership and services since they are quite simi-
lar in all the markets.
^^ When assigning points to the variable "DvP Model," multilateral netting gets 2 points, bilateral net-
ting 1 point, and gross settlement 0 points. These point assignments were decided upon because the
LAEM have considerable problems with liquidity. In section 2.3.2 above, the advantages and disadvan-
tages of the different methods of computing settlement obligations were discussed. As was noted, mul-
tilateral netting might be the best alternative for markets with low liquidity.

87
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88
while in Frankfurt clearing can be improved. Santiago and Lima have the riskier cus-
tody, clearing, and settlement processes of the sample. While all analyzed CSDs use a
computer-based mechanism with more than 90% of dematerialized stocks, Chile still
uses a combination of paper and computer-based mechanisms with more than 10% of
physical shares held in the form of paper and a small percentage held as physical
stock certificates. Settlement assurance can also be improved in Santiago, where, as in
Lima, a guarantee fund is still under construction and securities lending is generally
not regulated. The score of settlement in Lima is also one of the lowest in the sample.

3.3.10 Trading Architecture Index

Similar to section 3.3 above, this section also has three goals: to determine (1) how
different the trading processes of the LAEM are in comparison with some developed
markets, (2) if there are any differences in the trading processes in the LAEM, and (3)
if there are such differences, which factors are responsible for them. To answer these
questions, the TA-Index was developed. It is calculated by averaging the three in-
dexes treated earlier in this section: the I-Index, the TS-Index, and the CCS-Index (see
Figure 3.4). Due to limited information, the TA-Index could be computed only for the
seven LAEM, Paris, and Frankfurt. London and the NYSE were also included, but un-
fortunately it was not possible to find sufficient information.

The TA-Index shows three interesting results. First, it confirms the existence of a con-
siderable heterogeneity in the trading architectures of the Latin American stock mar-
kets. The LAEM could thus be divided into three groups. The group with the highest
TA-Index comprises Sao Paulo and Mexico. Buenos Aires, Lima, Santiago, and Cara-
cas are located in the middle group, while Bogota falls in the group with the lowest
TA-Index. Second, compared to developed markets, the TA-Index of all Latin Ameri-
can exchanges is significantly lower. And third, the factors responsible for the weak-
nesses of the Latin American trading architectures are different for each market.

Buenos Aires, Colombia, and Caracas - and, to a lesser extent, Sao Paulo and Mex-
ico - have to reinforce the role of their market-makers. The trading system is particu-
larly weak in Colombia and Lima. Finally, the CCS-Indexes of Santiago, Lima, and
Bogota are low, while the CCS-Indexes of the other Latin American exchanges are
comparable to the indexes of developed exchanges.

89
Table 3.18. Trading Architecture Index

l-lndex TS-lndex CCS-lndex TA-lndex

NA 0,56 0,72 0,64*

Sao Paulo 0,57 0,73 0,72 0,68
Santiago 0,86 0,54 0,39 0,59
Colombia 0,43 0,42 0,58 0,48
Mexican 0,57 0,71 0,83 0,70
Lima 0,86 0,49 0,50 0,62
Caracas 0,29 0,64 0,83 0,59

Paris 0,71 0,86 0,78 0,79

Frankfurt 0,71 0,87 0,72 0,77
London 0,70
New York 0,83
Nasdaq
The TA-Index is computed by averaging the I-Index, TS-Index, and CCS-lndex.
* For Buenos Aires, only the TS-Index and the CCS-lndex were averaged since not enough information
for the I-Index could be found.

3.4 Conclusions
The principal aim of this chapter has been to compare the state of development and
trading architecture of the LAEM and four developed markets. To evaluate the com-
parisons, we sought to answer three questions: (1) How heterogeneous are the impHcit
trading costs among the LAEM? (2) To what extent are the trading costs in the LAEM
different from those in developed countries? And (3) which factors explain the differ-
ences? To answer them, two main indexes were constructed: the Development State
Index and the Trading Architecture Index. First, based on the literature, the most im-
portant elements of each index were identified. And then the indexes were computed
with the help of these elements.

As the literature makes clear, stock market development is a multifaceted concept.

Thus, in order to analyze stock market development in each LAEM, four market indi-
cators were identified as the most important: stock market size, liquidity, stock market
concentration, and number of quoted firms. Then a DS-Index was calculated with
these four development indicators.

90
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91
The results of the development indexes were conclusive. The LAEM are heterogene-
ous and the developed markets are more developed than the LAEM. According to the
development indexes, the Latin American stock markets can be divided into two
groups. First, the most developed stock markets are Brazil, Chile, and Mexico. Sec-
ond, the less developed markets are Venezuela, Colombia, Peru, and Argentina.
Among developed countries, the U.S. has the most developed stock market, followed
by the UK, Germany, and France. Compared to developed markets, the LAEM have
significantly lower development indicators. However, they improved faster than
France, Germany, the UK, and the U.S. during the analyzed period. There are four (of
five) development indicators that lead to these results: MC/GDP, VT/GDP, TO, and
the NQF. Regarding market concentration, there proved to be no difference between
Latin American and developed markets.

The trading architecture of the Latin American stock markets was analyzed and com-
pared with the TA-Index. Three elements were identified so as to describe and com-
pare the trading architecture: (1) intermediary, (2) trading system, and (3) custody,
clearing, and settlement. For each element, an index was constructed. Then, averaging
these indexes, the TA-Index was calculated.

The TA-Index shows interesting results. First, it confirms the existence of a remark-
able heterogeneity in the trading architectures in the Latin American stock markets.
Second, compared to developed markets, the TA-Index of all Latin American ex-
changes is significantly lower. And third, the factors responsible for the weaknesses
of the Latin American trading architectures vary among the markets.

To see the robustness of the Development State- and Trading Architecture-Indexes,

both indexes can be compared with trading costs. In Table 3.19 both indexes, as well
as implicit costs of trading and the ranking of the exchanges, are shown in parenthe-
ses. It can be observed that the exchanges with the lowest implicit costs of trading
have the highest DS- and TA-Indexes. This reflects the importance of the selected
components for each index and their relation to trading costs.

Finally, in the computation of the indexes their components were equally weighted.
This averaging procedure does not have a theoretical or empirical foundation. Rather,
the information on the components was aggregated in this form according to my own
criteria, which are based on the literature on trading architecture. If we were to con-

92
tinue calculating the indexes for the next years, it would be possible to test whether
this way of averaging the components is still correct, and if it proved not to be, the av-
eraging procedure could be easily changed. Were this to occur, the indexes designed
here might well provide a basis on which to develop new indexes that weight their
components according to the new information.

Table 3.19: DS- and TA-Indexes vs. Implicit Cost of Trading

Total Trading Cost Implicit Cost D-lndex TA-lndex

Buenos Aires 76,9 29,6 -0,60 0,64

Sao Paulo 58,0 21,4 -0,33 0,68
Santiago 84,3 38,6 -0,42 0,59
Colombia 97,5 42,2 -0,69 0,48
Mexico 61,7 27,3 -0,47 0,70
Lima 95,8 35,2 -0,59 0,62
Caracas 134,1 34,7 -0,75 0,59
Mean 86,9 32.7 -0,55 0,61
Std. Dev 25,8 7,1 0,15 0,07
Min 58,0 21,4 -0,75 0,48
Max 134,1 42,2 -0,33 0,70

Paris 29,5 6,7 -0,06 0,79

Frankfurt 37,7 13,4 0,25 0,77
London 54,5 15,2 1,36
USA 38,1 29,8 2,30
Mean 39,95 16,28 0,96 0,78
Std. Dev 10,48 9,73 1,08 0,01
Min 29,50 6,70 -0,06 0,77
Max 54,50 29,80 2,30 0,79
Implicit and Total Trading cost are from Domowitz, et. al. (2000).

93
4 Univariate Portfolio Approach

4.1 Introduction
In contrast to the large number of investigations on asset pricing behavior of U.S. and
other developed markets, there are few publications about Latin American stock mar-
kets. Moreover, the published papers, which test for "anomalies" at a stock level in
the Latin American markets, show contradictory results. For this reason and in order
to reconcile the results, one question is investigated in this chapter: Are there S-,
P/BV-, P/E-, and TO-effects in the LAEM for different sample periods, with different
grouping procedures, and different return estimation?

With the development of the Capital Asset Pricing Model, researchers have accepted
that risky investments would generally yield higher returns than risk-free investments.
However, it is not yet clear how the risk of an asset is to be evaluated and how risk
premia are to be determined. Empirical investigations in developed markets have
shown that stock returns are related to such variables as size (Banz (1981)), P/BV
(Stattman (1980)), P/E (Ball (1983)), and TO. However, few papers investigate these
relations in the LAEM. Publications analyzing the risk and returns in emerging mar-
kets are at country or firm level. Since the goal here is to analyze only the seven major
Latin American stock markets, the analysis carried out at firm level.

Two important papers show contradictory results for the LAEM. Rouwenhorst (1999)
found that the return factors in emerging markets are similar to those documented for
many developed markets. An average across all emerging markets shows that small
stocks outperform large stocks and value stocks outperform growth stocks. Rouwen-
horst (1999) does not find that average returns are related to share turnover. By
contrast, Claessens et al. (1995) show that the Latin American markets may have a
size effect, though it is not necessarily restricted to the smallest size portfolios. It was
only in Mexico that the small portfolio had significantly higher annual returns than the
portfolio with the largest stocks.

Two objectives are pursued in this chapter. The first is to investigate whether the fac-
tors explaining the return variation in the LAEM are similar to those documented for
many developed markets using a portfolio approach. In particular, we wish to investi-
gate whether the firm size and the ratios price-to-book-value, price-to-eamings, and

94
the turnover, influence the expected returns. To undertake a theoretical analysis in or-
der to select among these would exceed the scope of the present study. Their selection
is mainly motivated by the existing evidence from the U.S. and other developed mar-
kets, and at the same time by the practice of fundamental security analysts (see Chan,
Hamao, and Lakonishok (1991)). S, P/BV, and P/E are all scaled by price; thus, it
would be worthwhile to test whether the return premia are related to a stock character-
istic that is not multiplied by price and that at the same time helps investors to make
investment decisions. Liquidity satisfies both of these conditions; moreover, TO is
important to firms because less liquid stocks must pay extra premiums as compensa-
tion. This is why firms are interested in diminishing their capital cost by improving
their liquidity policy. Consequently, we test whether less liquid stocks pay extra pre-
mia.

The second objective pursued here is to find an explanation for the contradictory re-
sults obtained by Rouwenhorst (1999) and Claessens et al. (1995). Some reasons for
the contrary results are: (1) they use different sample periods, (2) they group stocks in
a different number of portfolios, (3) Rouwenhorst sorts stocks monthly but Claessens
et al. sorts them yearly, and (4) for the computation of portfolio returns they weighted
stocks in different ways. Therefore, in this chapter we conduct a simple portfolio ap-
proach by which stocks are sorted into one of three or six portfolios, the stock alloca-
tion takes place each month or year, and the calculated return are either equally or
value-weighted. Results of different sample periods are also compared. The construc-
tion of a portfolio is a common practice in empirical finance in order to analyze the
links between stock returns and variables such as S, P/BV, P/E, and TO.

The remainder of the present chapter is organized as follows: the next section presents
the empirical evidence from developed and emerging markets. In section 4.3, the da-
tabases used here are introduced and discussed. Stock market and return characteris-
tics are documented in sections 4.4 and 4.5, while the methodology (portfolio ap-
proach and the required previous computations) is described in section 4.6. In section
4.7 the results are discussed, that is, the findings are presented regarding the relation
between the average returns of the Latin American conmion stocks and market capi-
talization, market price-to-book-value ratio, the price-to-eamings ratio, and turnover.
The final section summarizes the results and points to open questions that will be in-
vestigated in Chapter 5.

95
4.2 Empirical Evidence
A large number of investigations in modem financial economics have sought to quan-
tify the trade-off between risk and expected returns. The CAPM acknowledges only
thatriskyinvestments generally yield higher returns thanrisk-freeinvestments. How-
ever, there is still no generally accepted theory that evaluates risk and determines risk
premia.

Initially, research supported the CAPM; however, subsequent investigations did not
accord with it (Roll (1977), Stambaugh (1982)). Fama and French (1992) tested em-
pirically a static version of the CAPM in order to explain the cross-section of realized
expected returns. They reported that when the premium for P (market risk) is close to
zero, other stock risks should be taken into account so that assets can be predicted ra-
tionally. Many attributes (or anomalies, since they are not explained by the CAPM)
that explain the cross-sectional average returns have been found. Among the most im-
portant attributes are the firm size, the ratios book to market, earnings to market, and
turnover.

Many theories have attempted to determine why the CAPM cannot explain the aver-
age stock returns. The joint null hypothesis that the expected returns are explained by
an equilibrium model and that the markets are efficient has played an important role
in the debate. Four main explanations have been given for the rejection of the null hy-
pothesis (Fama and French (1999)). The first and traditional one is from Fama and
French (1992, 1993). They argue that anomalies must be approximations of risk: the
higher average returns from the small 5-, high B/M-, and high £/P-stocks are the
compensations forriskin a multifactor asset pricing model. The second theory alleges
that investors set prices irrationally (De Bondt and Thaler (1987)). Investors are said
to overreact to new information, which then may cause stock prices to differ tempo-
rarily from their fundamentals. In recent years investors have valued strong stocks
with high returns and weak stocks with low returns. Daniel and Titman (1997) have
proposed a third explanation. They argue that firm characteristics rather than the co-
variance structure of returns appear to explain the cross-sectional variation in average
stock returns. The fourth and final theory proposed thus far is from MacKinlay
(1995). He maintains that the strong relations between the anomalies and the average
returns are the result of chance. However, Chan, Hamao and Lakonishok (1991) and

96
Fama and French (1998) have provided out-of-sample evidence against MacKinlay's
theory.

4.2.1 Evidence from Developed Markets

Numerous papers have analyzed the behavior of common stock returns. Most of these
investigations have been carried out for stock markets located in developed countries.
Since 1980 several empirical studies have demonstrated the presence of a number of
anomalies. The contradiction of the CAPM most frequently mentioned is the firm size
effect, which was first documented by Banz (1981). Banz empirically demonstrated
that the stock market capitalization and >9 explain the cross-section of average returns.
Based on market capitalization, Banz divided NYSE stocks into quintiles for the pe-
riod 1931 to 1975. The smallest quintile (stocks with the smallest market capitaliza-
tion) showed higher average returns than the other quintiles and indexes. Hawawini
and Keim (1996) grouped NYSE- and Amex-stocks into ten value-weighted portfolios
for the period 1962-1994. Their results showed a clear negative relation between size
and p-. the smallest size portfolio offered 8.8 % higher returns than the largest one. As
for the U.S. markets, numerous studies have documented the existence of size effect
in other developed markets. Chan et al. (1991) showed a significant negative relation
between size and expected returns for the Tokyo Stock Exchange. A size effect was
documented by Hawawini and Viallet (1988) for the stock market of France, and by
Corhay et al. (1988) for the UK.

Recently, the book-to-market effect has gained the attention of researchers. The B/M
ratio has been shown to have a significant predictive power with respect to the cross-
sectional average returns in some stock markets. The B/M effect was first documented
by Stattman (1980). He discovered that average returns on U.S. stocks are positive re-
lated to the B/M ratio. Rosenberg, Reid, and Lanstein (1985) have confirmed this re-
sult. With a sample of all nonfinancial firms listed on the NYSE, Amex, and Nasdaq,
Fama and French (1992) show that the relations between average return and size of
book-to-market are the strongest. Moreover, they argue that "although the size effect
has attracted more attention, book-to-market equity has a consistently stronger role in
average retums."^^ Chan et al. (1991) have shown for Japan that the book-to-market
ratio is statistically and economically the most important of the four variables they

*^ See Fama and French (1992), page 428.

97
analyzed in order to explain the cross-sectional average return. The book-to-market
effect has also been documented at the stock exchanges in London, Germany, France,
and Switzerland (Hawawini and Keim (2000)). Fama and French (1998) confirmed
the B/M effect for thirteen major countries.

The tradition of earnings-related investment strategies is old, but Basu (1983) was the
first to document it empirically. He studied the relation of the ratio £/P, market capi-
talization, and return on the NYSE for the period 1963-1980. Basu shows that, on av-
erage, high E/P stocks have higher risk-adjusted returns than low E/P stocks. In addi-
tion, the E/P effect is significant even after controlling for firm size. Fama and French
(1992) also find a strong univariate relation between the average returns and the E/P
ratio. For the Singapore Stock Exchange, Wong and Lye (1990) find that the size ef-
fect is apparently of secondary importance, when it is compared to the E/P effect. Re-
garding to stocks of both sections of the Tokyo Stock Exchange, Chan et al. (1991)
show that high E/P stocks outperform low E/P stocks. However, there is less evidence
of an E/P effect in other developed markets.^^

Another factor that is gaining in importance is Turnover. Amihud and Mendelson

(1986) show that cross-sectional expected returns are an increasing function of the
turnover for stocks traded in the U.S. markets. Brennan et al. (1996), Haugen and
Baker (1996), and Teh and De Bondt (1996) confirm that stocks with higher trading
activity tend to have lower expected returns. Hu (1997) finds that the Japanese stock
market supports the results of Amihud and Mendelson (1986). Using a cross-sectional
analysis, Hu discovered that stocks with higher turnover tend to have lower expected
returns. He used data from the Tokyo Stock Exchange from 1976 to 1993, and he used
stock turnover as a measure of liquidity.

4.2.2 Evidence of Emerging Markets

The trade-off between the expected returns and their associated risk determines the
benefits to an equity investor in the stock markets. Many factors must be considered
for the assessment of this trade-off in the LAEM: the underlying factors determining
the rate of return and its variability, the efficiency of domestic stock markets, the
regulatory, accounting, and enforcement standards, the different forms of transfer risk

Hawawini and Keim (2000) present a complete survey of papers in which the E/P effect is examined.

98
(e.g., barriers to the repatriation of capital), the ability to invest in a country, taxes and
other transaction costs (Claessens (1995)).

In recent years some papers have analyzed the relation between risk and returns for
emerging markets. They were carried out at country or firm level. On an aggregate
country level, the most frequently cited papers are those of Harvey (1995), Bekaert
(1995), Bekaert et al. (1998), and Fama and French (1998). Harvey (1995) docu-
mented that emerging markets exhibit high expected returns accompanied by high
volatility. He also pointed out that the stock returns of a Latin American stock market
are low correlated with other markets. Their low correlation with developed markets
has an advantage: it reduces the unconditional portfolio risk of a global investor. In
addition, he shows that the standard global asset pricing models fail to explain the
cross-section of average returns in emerging markets and that the returns of these
markets are more likely to be influenced by local information than in developed coun-
tries. On the other hand, Bekaert (1995) examined nineteen emerging equity markets
and observed that stocks with higher >^ offer lower expected stock retums.^^ Forming
two portfolios, Bekaert et al. (1998) examine a set of risk factors for several emerging
markets.^'* They register a size and a price-to-book effect. The price-to-eamings ef-
fect, however, is not as clear as the former. Finally, Fama and French (1998) also
tested for book-to-market, eamings-to-price, and size effects in sixteen emerging
markets. Their results conform with the evidence on developed markets. Small stocks
offer higher average returns than big stocks. Fama and French (1998) also found an
average difference between annual dollar returns on the high and low book-to-market
portfolios of 16.91% when countries are value-weighted and 14.13% when countries
are equally weighted. The value-premium is less reliable when they sort according to
eamings-to-price.

On an aggregate stock level, the results of the different studies are contradictory.
Rouwenhorst (1999) ranked stocks by country according to local P, S, prior six-month
return, B/M, and TO. From 1982 to 1997 stocks were sorted each month into three
equally weighted portfolios. For this period Rouwenhorst (1999) shows that the return

Furthermore, he develops a return-based measure of market integration and analyzes the relation be-
tween this measure, other return characteristics, and investment barriers. He concludes that each emerg-
ing market shows different degrees of market integration and that the differences are not necessarily
associated with barriers to investments.

99
factors in emerging markets are similar to those documented for many developed
markets. On average across all emerging markets, stocks exhibit momentum and small
stocks outperform large stocks, and value-stocks outperform growth stocks. Rouwen-
horst (1999) does not find that average returns are related to share turnover.

Claessens et al. (1995) also investigate the presence of some return anomalies in
twenty emerging stock markets. They use monthly data from the EMDB. Their sam-
ple period depends on the stock market.*^ For each market the authors rank stocks at
the beginning of each year by market capitalization. Thereafter, they assign stocks to
one of four portfolios and calculate the return on these portfolios for the subsequent
twelve months. At the end of each year, they recreate the portfolio scheme. In this
way, they generate a return time series for each portfolio. Their results show that the
Latin American markets may have a size effect, but it is not necessarily restricted to
the smallest size portfolios. It was only in Mexico that the small portfolio had signifi-
cantly higher annual returns than the portfolio with the largest stocks. Using an F-test
for equality of returns across all portfolios, they also investigated whether the size ef-
fect is significant. Their results show that any return difference between the four port-
folios was statistically significant at the 5% level.

In summary, the results of Rouwenhorst (1999) and those of Claessens et al. (1995)
contradict one another. Some of the reasons for the contradictions are: different sam-
ple periods, different numbers of portfolios, the frequency with which stocks were
sorted, and differences in the computation of portfolio returns (equally or value-
weighted). For these reasons, the causes that originate the contradictory results are
discussed in this chapter.

4.3 Database
Most of the data used in this chapter are from the EMDB of the IFC-S&P. For emerg-
ing markets, the EMDB provides current and historical statistics of series at stock, in-
dex, and market levels. Using different samples of stocks, the IFC-S&P calculates dif-
ferent indexes for each stock market. Among its wide range of indexes, the IFC
Global Index (IFCG) and the IFC Investable Index (IFCI) are the most important for

*^ They sorted the countries by risk factors into portfolios. Then they computed equally and value-
weighted returns for each portfolio and rebalance them four times per year.
*^ The time series start in 1976,1986,1987, or 1990, depending on the country.

100
our purposes. For differences among these two indexes, see Figure 4.1, below. For
both indexes, the IFC-S&P computes a vast number of alternatives.^^

IFCGobal(IFCG)
Q BroadBSt ccnsftuBntbase
D Covers 60 % of tt ale xchang9 market
C£pJtBl izafon
D No acjustments forforeign irvestmentrestricioTB
Q Daily calculEtiGn
• Indistry W e)©sc£icdated morthly

IPC Inves table (IFCI)

• Forei gnl n vest men t restrlcio ns in corpora ed
at oonstiLiert level
\j 9 z e a n d iqudity screens
• Corporste cross-hold ng& gDvernment
ownership adjusted
Q Daily calculEt icn
G Indistry hd e}esc£(ciJated nrx)rthly

IPCGF rentier Markets

• Introducedin 1996
D 20 markets
[] IndudBd if trading occurs regUarly;a cfvitytypicsllythn
• G r a d u d e b IFCGdaly series when iqiidity increases

Figure 4.1: IFC-S&P-Indexes

Source: The IFC Indexes: Methodology, Definitions, and Practices, IFC, July 1999

For their indexes, the IFC-S&P selects stocks as follows. At the date a market quali-
fies as emerging, the IFC-S&P begins the stock selection process. The first step of this
process is a survey of the market and of all listed companies and shares. While this
survey is repeated each year during an annual review process, additions and deletions
outside the annual review are nevertheless possible. In the second step, the guidelines
and profiles are defined in order to capture the real market in the IFCG Indexes. To
ensure it, the IFC-S&P uses three criteria:

First, actively traded stocks;

Second, target market share of 60-75% of total market capitalization; and
Third, industry diversification.

Finally, in order to graduate from index coverage, two criteria must be met: (1) GNP
per capita for an economy should exceed the World Bank's upper income threshold

For a description of the indexes, see the EMDB Guide and The EFC Indexes: Methodology, Defini-
tions, and Practices.

101
for at least three consecutive years, and (2) the investable market capitaHzation to
GDP ratio must be near the average of developed markets for three consecutive years.

The most popular indexes of the IFC-S&P are the Total Return Indexes, which are
calculated in U.S. dollars ([Link]) or in local currency ([Link]) for each
country. The [Link] are commonly used as a benchmark of the national stock
markets since they are consistent across national boundaries. [Link] indexes in-
clude all stocks used in the EMDB of the corresponding country.

The [Link] is computed by taking into account stock dividends and assuming
that dividends are reinvested across the entire index portfolio in proportion to the
capitalization of all stocks in the index. The [Link] indexes are market capitali-
zation weighted. Its period data are linked by the chained Paasche method. These in-
dexes are calculated on a price only and a total return basis, using end-of-week and
end-of-month data. In addition, it is common for firms in Latin America to issue more
than one class of shares. Then, according to its trading activity, one or more classes of
stocks are included in the IFCG-Index. Only the market capitalization of the selected
classes are included; not the entire capital of the company in question. ^^

In addition to their indexes, the IFC-S&P also publishes data used for the computation
of their indexes and valuation ratios. The principal time series published in the EMDB
include: closing price, number of shares outstanding, number of shares traded, divi-
dends, and new issues of shares. The IFC-S&P also computes three valuation ratios
for each stock and index: Price-to-eamings, price-to-book-value, and sash dividend
yield at a stock and index level.^^

Although the database of the IFC-S&P is very popular among researchers and practi-
tioners, it suffers from three sources of bias. First, the EMDB has some data process-
ing problems. For instance, sometimes the values are false or the database shows zero
when the entries have insufficient digits. Second, the stock and country selection cri-
teria force one to choose the most frequently traded and larger stocks of the most suc-
cessful countries. This winners selection induces a reemerging bias (Goetzmann and

^^ The IFC-S&P excludes mutual funds and other investment trusts.

^* In: The IPC Indexes: Methodology, Definitions, and Practices is described how they are computed.

102
Gorion (1996)). Third, the IFC-S&P began collecting infonnation in mid-1981 and
gathered data extending back to 1976 for the stocks of ten markets.^^

Most of the information used in the present chapter is from the EMDB. The following
are taken from the EMDB for each country: closing price, outstanding shares, market
capitalization, number of shares-traded (for the turnover), price-to-book value, price-
to-eamings, the capital adjusted rate (CAR), and the [Link].^ Only interest
rates are taken from the International Monetary Fund (the deposit rate for Argentina,
Chile, Colombia, Peru, and Venezuela; the money market rate for Brazil; and the
treasury bill rate for Mexico).

The period analyzed runs from May 1986 to November 1999 for all countries, except
Peru. The IFC-S&P began to collect information on Argentina, Brazil, Chile, and
Mexico in 1981, for Colombia and Venezuela in 1984, and for Peru in 1993. How-
ever, the period analyzed here begins in May 1986 because the IFC-S&P began to
publish P/BV and P/E at this time. Another reason we begin in 1986 is to avoid the
first years of data for each country, since they suffer from a back-tracking bias. For
Argentina, Brazil, Chile, and Mexico the IFC-S&P has published information on the
firms selected in 1981 since December 1975. For these five years, the EMDB might
suffer from a back-tracking bias, since successful firms in 1981 were not necessarily
the same as in 1975. Indeed, a firm that was successful in 1976 and had faired badly
by 1981 is not included in that database.

4.4 Characteristics of the Analyzed Stock Markets

According to the IFC-S&P's definition of an emerging market (see Chapter 2), all
Latin American stock markets are emerging markets. Unfortunately, the IFC-S&P
collects information only on some Latin American markets and of those, information

This is one reason why the present study starts in 1985. Information dating back to 1982 is used only
for the calculation of y^.
^ The IPC uses the last transaction price recorded at the stock exchange to determine closing price. The
IFC-S&P adjusts book values between balance sheet report dates by the amount of capital raised by
rights issues. In hyperinflationary economies, the IFC-S&P also adjusts earnings and book values. A
number of adjustments to market capitalization are made by the IFC-S&P in order to approximate more
closely the amount of a company's stock that is traded in the market. This includes recognizing statu-
tory limits on foreign ownership, removing capital owned by the government, and removing ownership
by other constituents (cross-holdings). In addition, the IFC-S&P makes adjustments when a company
issues new shares, declares a rights issue, stock splits, or stock dividends. Furthermore, the IFC-S&P
corrects its series for several kinds of unusual corporate actions. For a complete discussion of the ad-

103
on the smaller markets is incomplete. Therefore, the stock markets analyzed here
number only seven: Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Vene-
zuela. Some summary statistics for these markets are provided in Table 4.1.

From Table 4.1 one can see that the number of firms and the market capitalization in
each LAEM are small compared to some developed markets, such as the stock ex-
changes of New York, Japan, London, and Frankfurt (NYSE, TSE, LSE, and FSE).
However, the number of stocks in the EMDB are comparable to the MSCI portfolios
for developed countries.^^ It is also surprising that the capitalization in some Latin
American markets is larger than one might have suspected.^^ The total market capi-
talization of the LAEM was US$ 434.4 billion at the end of June 1992. From June
1992 to June 1999 it grew 65.7%. Despite this growth, the weight of the LAEM on
the total market capitalization of the IFCG Composite Index diminished from 35% in
1992 to 22% by the end of 1999.

4.5 Return Characteristics

The monthly stock returns for the Latin American stock markets under consideration
here will be analyzed in this section. In order to compare the returns across markets,
they are calculated in US Dollars. In Table 4.2 some properties of the monthly returns
are presented. The monthly mean returns range from 3.62% for Argentina to 1.35%
for Peru. However, the standard deviation seems to be correlated with the mean re-
turns. Argentina has the highest standard deviation, and Peru has the second smallest.
Compared to developed markets, the average returns and standard deviation of the
LAEM are often higher.

justments made to the series, see 'The IPC Indexes: Methodology, Definitions, and Practices," IPC,
July 1999.
^^ See Harvey (1991).
^ Several factors have been important in the increase of capital flows going to the LAEM. The decline
in international interest rates (Calvo, Liderman, and Reinhart (1993)), improved domestic policies and
better growth performance (Chuhan et al. (1993)), as well as market liberalization (Claessens and Rhee
(1994)), have encouraged the increase of capital flows to these markets.

104
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106
It is also important to notice the differences between mean and median returns. For
example, if we consider Argentina's median returns, it is surprising that this country
no longer provides the maximum returns in the region. The big differences between
mean and median are most likely due to the returns distribution. It is only in the case
of Chile that one cannot reject the null hypothesis at a 5% significance level of normal
distribution. As a consequence, statistical inference might be somewhat hazardous.

The Latin American markets offered a higher mean return with a higher standard de-
viation than many other emerging markets during the period from May 1986 to No-
vember 1999. In the Latin America markets, the monthly average return in US$ was
2.47% with a standard deviation of 7.39%. The average returns of Latin America are
about 2.8 times higher than the average returns of the MSCI Germany Index and 2.6
times the MSCI World Composite Index. The standard deviation is about 1.2 times
higher than the standard deviation of the MSCI Germany Index and about 1.8 times
higher than the standard deviation of the MSCI World Index. Compared to the Asia
[Link] Index, the Latin America [Link] conferred higher returns, but
with standard deviation that was a 1.82% higher. For the crisis period from January
1996 to November 1999, the Latin American [Link] Index was second among
the four regional [Link] Indexes with a monthly mean return of 1.11%.

Table 4.3: Return Correlation between the Latin America IFCG Indexes

ARGJFCG BRAJFCG CHUFCG COLJFCG MEXJFCG

ARGJFCG ... 0,017 0,135
0,189
BRAJFCG -0,039 ... 0,099
0,088
CHIJFCG 0,134 0,282 ...
0,207
COLJFCG 0,013 0,165 0,191

MEXJFCG 0,257 0,183 0,418 0,093

VEN IFCG 0,104 -0,027 0,052 0,229 0,067

All monthly returns of the market IFCG Indexes are in US Dollars. The market return cross-country
correlations are shown for the period Jaunary 1976 to November 1999 above the diagonal and from
May 1986 to November 1999 below the diagonal. The correlation coefficient of Peru was not included
due to a lack of information.

107
The European emerging markets offered 2.4%. Both regions had higher mean returns
than Asia (0.01%) with almost the same standard deviation.^^

The autocorrelation coefficients at lag 1 and 2 (n and r2), and the partial autocorrela-
tion coefficient for lag 2 (r22), are also reported in Table 4.3. Surprisingly, the n is
larger than 20% for three of the seven Latin American markets (i.e., for Chile, Co-
lombia, and Mexico). Furthermore, for Mexico the partial autocorrelation coefficient
for lag 2 (r22) is higher than 15%. On the region level, the LAEM have the highest n
but the lowest r2 and second lowest r22'

The return correlation between the Latin American IFCG Indexes are shown in Table
4.4 for two periods. The correlation across the LAEM is low - compared to the corre-
lation of the developed markets reported in Harvey (1991)^"^ - and between Brazil and
Venezuela it is even negative. For the period from 1976 to 1999, the average cross-
country correlation of five Latin American markets was 12.24%. From 1986 to 1999
the average cross-country correlation increased to 14.15%.^^ However, from January
1993 to November 1999 the average cross-country correlation rose to 40.43% for the
LAEM (see Table 4.4).^^ The stock market liberalization, that the LAEM suffered
during the '90s explains the great increment of the cross-country correlation.

In sunmiary, the Latin American markets have high mean returns with high standard
deviations. Their autocorrelation is significantly higher than in the developed markets.
The returns are not normally distributed, except for in one country. The average cross-
country correlation in these markets used to be low. However, in the '90s they have
been increasing significantly as a consequence of the reforms undertaken. Because

^^ The standard deviation for this period for Asia, Europe, and Latin America is 8.2%, 9%, and 9.1%,
respectively.
^^ Harvey (1991) reported an average cross-country correlation of 41% in 17 developed markets for the
period February 1970 to May 1989.
The average country correlation was computed for six stock markets.
'^ Bakaert and Harvey (1995) show that the degree of market integration changes over the period.

108
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109
these characteristics cause the LAEM to differ from other markets and because the
LAEM offer independent samples, it is worthwhile to study the LAEM.

4.6 Methodology
4.6.1 Portfolio Approach

The construction of portfolio is a common practice in empirical finance to analyze the

link among stock returns and some variables such as 5, P/BV, P/E, and TO (see for
example Fama and French (1992, 1993, 1998), Banz (1981), Hawawini and Keim
(1996), Harvey (1995), Bekaert et al. (1998)).

The portfolio approach implemented here is based on Rouwenhorst (1999) and Claes-
sens et al. (1995) and it consists of 5 steps. (1) Stocks are ranked according to one ob-
servable firm variable (here, 5, P/BV, P/E or TO) at the beginning of a given period
(here, of each month or year). (2) The stocks are grouped into the portfolios (here,
three or six). (3) The returns (here, equally or value) are computed for each month and
each portfolio. Using this process, a return time series is generated. (4) For each port-
folio its average return, volatility, and its average TO, P/E, P/BV, 5, and P, are com-
puted. And (5) the returns of the portfolios are compared and tested to determine
whether their differences are statistically significant, that is, whether the link among
stock returns and 5, P/BY, P/E, or TO is statistically significant.

4.6.2 Prehminary Computations

Before beginning to compute returns, some preliminary computations are required.

First, prices are adjusted for corporate actions, such as stock splits, stock dividends,
rights issues, new issues of stock, stock cancellations for constituents, and the addition
or deletion of constituents. Second, the returns of firms with several classes of shares
are calculated. And third, a y^series is computed for each stock.

The prices of each security are scaled by the CAR,^^ which corrects the prices for
changes in the capitalization caused by a stock split, a stock dividend, or a rights is-
sue. The simple returns are then calculated as the sum of the adjusted price apprecia-
tion and of the dividend return.

^^ Price and capital adjusted rates are from EMDB. The price is the price per share of the stock at the
end of the "Last Trading Date." These are actual prices; they are not adjusted to changes in capitaliza-
tion (for example, a two-for-one split).

110
r, =—— ' '' - 1 , (4.1)

where ru is the return of the stock / in t. Pit and Pij.i are the price of stock / at t and
t-1, respectively. CARit and CARitj are the capital adjust rate at time / and t-1 of stock
/, and Dit are the dividends in t of /.

It is common in the LAEM for firms to have several classes of shares. The returns of
these firms are calculated as the returns of a value-weighted portfolio of the out-
98
standing securities.

''u=Lv^ ^^." (4.2)

where n^ is similar to (4.1), Caps,t.i is the market capitalization of class s in t-1 and
TotCapit-i is the capitalization sum of all included share classes of firm / in t-1.

A monthly P for each stock is estimated with the help of the modified method of
Scholes and WilUams with one lag for each stock.^^

'i. = ^ i + >^'*^..+^,

\ m,t' m,t—\ I

where r^ and r^-i are like in Equation {\.\),Rm,t and Rm,t-i represent the return of the
[Link] Index in t and t-1, respectively; cor(Rm,t, Rm,t-i) is the correlation be-
tween the market returns in t and t-1, and Et and EM are the error terms in t and t-1, re-
spectively.

To compute j3, the returns of each stock are regressed on the [Link] Index of
firm's country of origin. Due to non-synchronous trading, one lag of the index is in-
cluded. In Table 2 we saw that the LAEM have high autocorrelation coefficients at lag
1 but low at lag 2. This characteristic can be observed if two lags are used in the re-
gression: in the first lag more than 50% of the y^ coefficients are significant, while for

This is done only with the share classes included in the EMDB.
^ In Zimmerman (1997) there is a complete discussion of the alternative methods for computing J3.

Ill
the second lag only 15% were. Therefore, only one lag should be taken into consid-
eration in order not to diminish the efficiency of the estimated p. One lead has also
been tested, but almost all y^"^ are insignificant. Zinmierman (1997) compares alterna-
tive methods for estimating ^ for German stocks. He noted that the Dimson P is as
good as the modified P of Scholes and Williams (MSWB). I prefer to use the MSWB
because, as Fowler and Rorke (1983) have convincingly shown, the derivation of the
Dimson /?is incorrect. From 24 up to 48 months of prior historical returns are used to
obtain the >^s.

4.7 Results
In this section the relation between stock portfolio returns and 5, P/BV, P/E, and TO is
analyzed for the seven Latin American markets of concern here. As explained above,
the portfolios are first constructed and then their returns are computed.

4.7.1 3-Portfolio Approach

The relation between average stock returns and 5, P/B, P/E, and TO is conducted in
this chapter at portfolio level. The stocks are listed according to their 5, P/BV, P/E,
and TO at the beginning of either each month or each year. Then stocks are assigned
to one of three portfolios. The top and bottom portfolios {PI and P3) each has 30% of
the stocks, while the middle one (P2) has 40%. The next step is to calculate equally or
value-weighted monthly^^ returns for each of the portfolios for the next month or
subsequent twelve months. Finally, we derive a series of monthly returns from May
1986 to November 1999 for all portfolios. ^^^ In a similar way, a time series for portfo-
lio capitalization, value-weighted P/BV, P/E, TO, and >^ is also calculated.

[Link] Value and Equally Weighted Stocks

Tables 4.5 to 4.8 report value and equally monthly returns, value-weighted TO, value-
weighted P/BV, value-weighted P/E, value-weighted P, value-weighted 5, and other
characteristics for the portfolios. These variables are calculated for each of the three
portfolios for each Latin American stock market.^^^ The grouping procedure is re-

*^ Value-weighted returns are calculated only for portfolios sorted each month.
^"^ The sample periods for Colombia and Venezuela range from January 1987 to November 1999, and
the sample period for Peru ranges from January 1993 to November 1999.
^^^ There are twelve portfolios per market, three for each of the four variables.

112
peated every month. Only in the case of P/E sorted portfolios is there a fourth PO port-
folio for stocks with negative P/E.

Portfolios Sorted by Size

In Table 4.5 the value-weighted returns of portfolios with stocks sorted by S are
shown. It can be seen that the average returns of small portfolios {PI) are higher than
the returns of the large portfolios {P3) in five markets (Argentina, Brazil, Chile, Mex-
ico, and Venezuela), whereas for the other two markets, the middle portfolios (P2)
have the highest returns. Only the PI portfolios of Mexico and Venezuela have the
highest returns with the smallest p. However, in any stock market the return differ-
ences between PI and P3 are significantly different from zero. The returns of equally
weighted portfolios confirm the results of value-weighted portfolios: The return dif-
ference (P1-P3) is any stock market statistically different from zero. The results of the
sample used here (April 1986 to November 1999) do not confirm the result of Rou-
wenhorst (1999) for the Argentinean and Mexican markets.

One might wish to argue that the absence of a size effect in the LAEM is due to the
stock selection criteria employed by the IFC-S&P. However, the differences between
the three portfolios in terms of the market capitalization are overwhelming. For exam-
ple, in Argentina the largest portfolio represents 82% of the market capitalization of
the three portfolios, even though this portfolio contains less stocks than the middle
one.

Portfolios Sorted by P/BV

Panel A of table 4.6. shows the results of Value weighted portfolios sorted by P/BV.
In Brazil, Chile, Mexico, and Venezuela the PI portfolios have the highest returns,
while in Argentina, Colombia, and Peru the P2 portfolios have them. Portfolios with
the highest returns have the lowest fi only in two markets. In the other markets, port-
folios have a similar /?. From the seven analyzed markets, only Brazil, Chile, and
Mexico have a return difference (PI-PS) with a r-statistic higher than 1.5. However,
the PI portfolio of Brazil has the highest y^, but the J3 differences between the PI and
PS portfolios seems to be too small to explain the 2.7% return difference of both port-
folios. These results are different from those obtained by Fama and French (1998) and

113
Claessens et al. (1996). One reason for the differences might be the way stocks are
weighted in the portfoUos. Therefore, equally weighted portfolios are also calculated.

Table 4.5: Summary Statistics for Portfolios Sorted by Size

Panel A: Characteristics of Vaiue-Weighted Portfoiios

/^gentina Brazil Chile 1Colombia Mexico Peru Venezuela

Return PI (low) 0.0387 0.0241 0.0272 0.0078 0.0334 -0.0007 0.0196

t 1.8 1,4 3,6 0,9 3,2 -0,1 1,4
Turnover 0.0763 0.0405 0.0076 0.0081 0.0463 0.0745 0.0223
P/E 5,3 5,5 11,2 8,8 9,9 10,4 15,6
P/BV 1,0 0,6 1,5 1,0 1,2 1.2 1,5
Beta 1,2 1,1 1,2 0,8 0,9 1.2 1.0
Capitalization 57191,6 136172,2 199269,2 32333,0 296274,8 3027,8 35354,3
N 8,8 15,7 10,5 6.6 14,3 9.0 4,5
Return P2 0.0392 0.0360 0.0204 0.0189 0.0244 0.0020 0.0149
t 2,0 2,2 3,1 2,5 2,6 0,2 1.2
Turnover 0.1963 0.0309 0.0075 0.0068 0.0447 0.0506 0.0160
P/E 12,6 6,1 10,9 15,1 0,6 14,7 18,3
P/BV 1,3 1,1 1,8 1,7 1,6 1.8 2,6
Beta 1,1 1,0 1,1 0,9 0,9 1.1 1.0
Capitalization 375133,2 1269194,9 918467,7 268808,9 2060179,5 53715,3 162478,3
N 11,7 21,2 14,6 9,3 19,7 12,3 5,7
Return P3(high) 0.0358 0.0206 0.0247 0.0181 0.0304 0.0064 0.0170
t 2,2 1,5 3,8 2,2 2,9 0,6 1,4
Turnover 0.0344 0.0480 0.0098 0.0061 0.0426 0.0226 0.0216
P/E 37,8 6,0 14,6 18,1 30,2 33,6 17,8
P/BV 1,9 1,0 2,1 1.6 1.9 3,5 2,7
Beta 0,9 1,2 1.1 0,9 1.1 1,0 1,0
Capitalization 1986676,1 16590521,7 3610211,1 579445,5 12277177,5 696280,7 478214,1
N 8,8 16,2 10,6 6,7 14,5 9,2 4.5
Return P1-P3 0.0029 0.0035 0.0029 -0.0103 0.0030 -0.0072 0.0026
StdAbw 0,1 0,2 0,1 0,1 0,1 0,1 0,1
t 0,3 0,3 0.6 -1.5 0,4 -0,7 0.3

Panel B: Returns of Equally-Weighted Portfolios

Argentina Brazil Chile <Colombia IMexico Peru Venezuela

Return P1-P3 0.0199 0.0067 0.0022 -0.0055 0.0054 -0.0016 0.0012

StdAbw 0,2 0,2 0,1 0.1 0,1 0,1 0,1
t 1,2 0,5 0,5 -0,7 0.7 -0,1 0.1
Return PI 0.0533 0.0297 0.0273 0.0130 0.0351 0.0027 0.0213
StdAbw 0,3 0,2 0,1 0,1 0,1 0,1 0,2
t 2,0 1,7 3.6 1.3 3,1 0,2 1,6
Return P2 0.0417 0.0346 0.0206 0.0187 0.0219 0.0003 0.0156
StdAbw 0,3 0,2 0,1 0,1 0,1 0,1 0,1
t 1,9 2,1 3.2 2,5 2.4 0,0 1.3
Return P3 0.0334 0.0230 0.0251 0.0185 0.0296 0.0042 0.0201
StdAbw 0,2 0,2 0,1 0,1 0,1 0,1 0,1
t 1,6 2,2
L9- M^ i^ 2£. 1,7
Value-weighted monthly returns ( t in parentheses), price-to-eamings (P/E) ratios, market price-to-book
price (P/BV) ratios, and TO for portfolios sorted every month by size. The modified Scholes-Williams jS
and the market capitalization for each portfolio are reported. The market capitalization is expressed in
millions of U.S. dollars, t is the value-weighted mean return to its standard error. N denotes the average
number of stocks in each portfolio. Returns of equally weighted portfolios are presented in the last part.

114
The average return of the equally weighted and value weighted portfolios show simi-
lar results (see panel B of table 4.6). The r-values for three markets (Brazil, Chile, and
Mexico) are higher than two. These results are still different from those of Fama and
French (1998).^°^ Furthermore, we also reject the possibihty found by Claessens et al.
(1996) of a P/BV effect that would not be restricted to the lowest P/BV portfolio.
Therefore, the discrepancies in the results are caused by the different sample periods.
This gives us a hint, that the sample period used by Fama and French (1998) and
Claessens et al. (1996) was not long enough.

Portfolios Sorted by PIE

Table 4.7 presents the results of portfolios sorted by P/E. Four portfolios were
formed; PO contains stocks with negative P/E values. Pi, P2, and P3 are sorted in the
same way as by size and book-to-market.

According to value-weighted returns, return differences (P1-P3) are significant at a

5% level in four stock markets. In five markets, portfolios PI have the highest returns,
but only in Argentina and Venezuela do the Pis have the highest return with the low-
est J3. However, in Argentina the return difference is not significant at a 5% level. In
Brazil, Colombia, and Mexico, the Pis offer the highest return but with the smallest
y^s, though the differences in y^ might be too small to explain the differences of the
portfolio returns. In Brazil and Mexico the return differences are significant at a 5%
level. Furthermore, the return difference {P1-P3) is statistically different from zero in
Chile, but P2 offers a higher average return with almost the same J3.

Equally and value-weighted portfolios show slightly different results. The r-statistic of
the return difference (P1-P3) is higher in all Latin American markets for equally
weighted portfolios, since the low P/E portfolios always have higher returns than the
high P/E portfolios. The increases in the r-values are important especially in Argen-
tina and Colombia, since the return differences (P1-P3) become significant at a 10%
significance level.

' They find r-values higher than 1.5 for Brazil, Colombia, and Venezuela. I also computed the returns

115
Table 4.6: Summary Statistics for Portfolios Sorted by P/BV

Panel A: Characteristics of Value-Weighted Portfolios

Argentina Brazil Chile Colombia Mexico Peru Venezuela

Return Pl(low) 0.03158 0.03474 0.03235 0.01477 0.03557 -0.00263 0.02447

t 1,5 1,8 4,5 1,4 2,9 -0,2 2,5
Turnover 0.07923 0.03613 0.00983 0.00831 0.04169 0.06276 0.02374
P/E 13,1 7,7 10,2 -13,0 -4,4 8,4 14,9
P/BV 0,6 0,3 0,8 0,5 0,7 0,7 1,0
Beta 1,1 1,4 1,1 0,9 1,0 1.2 1,1
Capitalization 157739.8 3906145,3 634752,9 10599,0 1334092,7 11722,0 92521,9
N 8,5 16,0 10,4 6 ^ 14,2 8,7 i5
Return P2 0.03971 0.02740 0.02680 0.02381 0.03060 0.00831 0.01869
t 2,1 1,7 4,1 2,7 2,9 0,6 1,7
Turnover 0.25626 0.05359 0.00856 0.00657 0.04534 0.03002 0.02343
P/E 29,8 9,1 12,2 18,8 26,9 27,3 20,2
P/BV 1,2 0,8 1,6 1.2 1,4 1,9 1,8
Beta 0,8 1.2 1,1 0,9 1,1 1,1 1,1
Capitalization 700200,7 5958456,6 2133510,9 49115,1 6004664,0 177356,9 314272,9
N 12,0 21,3 14,8 9,1 19,4 12,0 57
Return P3(hlgh) 0.03795 0.00713 0.02165 0.01101 0.02415 0.00363 0.01286
t 2,1 0,5 3,1 1,6 2,5 0,3 2,1
Turnover 0.04637 0.03909 0.00911 0.00562 0.04145 0.02364 0.01476
P/E 37,6 5,0 15,6 17,2 32,5 30,7 16,4
P/BV 2,4 1.8 3,1 2,6 2,6 4,0 4,3
Beta 0,8 0,9 1.1 0,8 1,0 1,0 0,9
Capitalization 1579449,8 7950823,5 1929040,5 46764,1 7240855,1 538424,7 265385,5
N M 16,2 10,5 6A^ H3 8,8 4,5
Return P1-P3 -0.00636 0.02760 0.01071 0.00376 0.01142 -0.00626 0.01286
StdAbw 0,1 0,2 0,1 0,1 0.1 0.1 0,2
t -0,6 2,3 2.1 0,5 1,5 -0,4 1.1

Panel B: Returns of Equally-Weighted Portfolios

Argentina Brazil Chile Colombia Mexico Peru Venezuela

Return P1-P3 0.02214 0.03379 0.01220 0.00415 0.01678 0.00069 0.00807

StdAbw 0,2 0,1 0.1 0,1 0.1 0,1 0,1
t 1.3 3,0 2.4 0,6 2,2 0,1 0,7
Return PI 0.05424 0.04601 0.03179 0.01316 0.03865 0.00116 0.02181
StdAbw 0,3 0,2 0.1 0,1 0,2 0,1 0,2
t 2,0 2.4 4,2 1.4 3.3 0,1 1.5
Return P2 0.03962 0.02101 0.02219 0.02354 0.02829 0.00507 0.01802
StdAbw 0,3 0,2 0.1 0,1 0.1 0.1 0,2
t 1,9 1.4 3,4 2,9 2,9 0.3 1.4
Return PS 0.03210 0.01222 0.01972 0.00900 0.02187 0.00047 0.01374
StdAbw 0,2 0,2 0,1 0,1 0,1 0.1 0,1
t 1,8 0,9 3,0 1,3 2.4 0.0 1,3

Value-weighted monthly returns ( t in parenthesis), price-to-eamings (P/E) ratios, market price-to- book
price {P/BV) ratios, and TO for portfolios sorted every month by P/BV. The modified Scholes-Williams
fi and the market capitalization for each portfolio are reported. The market capitalization is expressed in
millions of U.S. dollars, t is the value-weighted mean return to its standard error. ^V denotes the average
number of stocks in each portfolio. Returns of equally weighted portfolios are presented in the last part.

for their period and obtained similar results to them.

116
Table 4.7: Summary Statistics for Portfolios Sorted by P/E

Panel A: Characteristics of Value-Weiglited Portfolios

Argentina Brazil Chile Colombia Mexico Peru Venzuela

Return Pl(low) 0.04335 0.03739 0.02660 0.02153 0.03698 0.00429 0.04253

f 2.0 2.1 3.6 2.1 3.2 0.3 3.0
Turnover 0.78665 0.04752 0.00965 0.00786 0.05350 0.03073 0.01957
P/E 9.3 5.4 8.5 7.2 7.9 8.9 7.6
P/BV 1.5 0.6 1.7 1.1 1.4 1.7 2.0
Beta 0.8 1.2 1.1 0.9 1.1 1.0 1.0
Capitalization 157739,8 351470.0 2624311.5 828180.6 180257.7 4656031.4 56315.3
N 6.4 11.6 9.9 6.1 11.9 7.8 4.2
Return P2 0.03879 0.02518 0.02940 0.01781 0.03359 0.00950 0.01161
t 2.2 1.6 4.2 2.4 3.2 0.9 1.0
Turnover 0.05764 0.04501 0.00921 0.00692 0.04346 0.02492 0.01925
P/E 27.5 11.5 12.8 11.8 11.2 17.5 13.7
P/BV 2.0 1.1 2.0 1.7 1.9 2.7 2.5
Beta 0.8 1.1 1.1 0.9 1.1 1.1 1.0
Capitalization 700200,7 1236615.2 8419571.7 2226358.9 370301.3 5966891.7 287937.2
N 8.5 15.7 13.5 8.5 16.2 10.7 5.4
Return P3(high) 0.03266 0.01119 0.01529 0.01201 0.02117 -0.00351 0.00718
t 1.9 0.8 2.4 1.5 2.4 -0.3 0.6
Turnover 0.04121 0.03568 0.00727 0.00533 0.03471 0.02713 0.01966
P/E 100.4 24.8 22.5 32.2 208.2 50.1 32.9
P/BV 1.7 1.4 2.4 1.7 2.4 3.8 3.0
Beta 0.8 1.0 1.1 0.9 0.9 1.1 1.0
Capitalization 1579449,8 668031.9 5550345.7 1563585.2 304720.6 3276271.2 374738.8
N 6.2 11.6 9.9 6.1 11.9 7.7 4.2
Return P1-P3 0.01070 0.02620 0.01130 0.00952 0.01580 0.00780 0.03536
StdAbw 0.1 0.1 0.1 0.1 0.1 0.1 0.1
t 1.2 2.3 2.4 1.1 2.5 0.7 3^

Panel B: Returns of Equally-Weighted Portfolios

Argentina Brazil Chile Colombia l\/lexico Peru

Return 0.02273 0.02362 0.01832 0.01109 0.02303 0.03581 0.03987

StdAbw 0,2 0,1 0,1 0,1 0,1 0,1 0,1
t 1,3 3,0 2,4 0,6 2,2 0,1 0,7
Return PI 0.04206 0.03581 0.03253 0.02192 0.04364 0.00651 0.04263
StdAbw 0,3 0,2 0,1 0,1 0,2 0,1 0,2
t 2,0 2,4 4,2 1,4 3,3 0,1 1,5
Return P2 0.02769 0.02538 0.02743 0.01906 0.02896 0.02128 0.01255
StdAbw 0,3 0,2 0,1 0,1 0,1 0,1 0,2
t 1.9 1,4 3,4 2,9 2,9 0,3 1,4
Return P3 0.01933 0.01219 0.01421 0.01083 0.02061 -0.01959 0.00276
StdAbw 0,2 0,2 0,1 0,1 0,1 0,1 0,1
t 1,8 0,9 3,0 1,3 2,4 1,3

Value-weighted monthly returns ( t in parenthesis), price-to-earnings (P/E) ratios, market price-to- book
price (P/BV) ratios, and TO for portfolios sorted every month by P/BV. The modified Scholes-Williams
fi and the market capitalization for each portfolio are reported. The market capitalization is expressed in
millions of U.S. dollars, t is the value-weighted mean return to its standard error. ^V denotes the average
number of stocks in each portfolio. Returns of equally weighted portfolios are presented in the last part.

117
Table 4.8: Summary Statistics for Portfolios Sorted by Turnover

Panel A: Characteristics of Vaiue-Weiglited Portfolios

Vene-
Argentina Brazil Chiie IColombia Mexico Peru zuela

Return Pl(low) 0.02900 0.01443 0.02050 0.01191 0.03167 0.00248 0.00934

t 1,6 1,1 3,0 1,4 3.4 0,2 0.8
Turnover 0.01099 0.01130 0.00244 0.00284 0.01471 0.01745 0.00562
P/E 28,9 -0.9 13,4 16,6 81.2 30,4 17.1
P/BV 1.7 1.4 3,9 2,0 1.9 3,3 3.2
Beta 0,7 0,9 1,0 0,8 0.8 1.1 0,9
Capitalization 801533,6 3130390,9 786280,9 166814,9 1730296,2 313576,7 162378,9
N 8.5 16.1 10,5 6.6 14,0 8.7 4,5
0.02392 0.01889 0.02755 0.00106 0.01599
t 2,4 1,1 3,5 2,4 2,6 0.1 1.3
0.03982 0.02567 0.00591 0.00646 0.03739 0.03166 0.01338
P/E 36,2 5,7 14,7 15,5 21.8 31.4 18,6
P/BV 1,9 1,0 4,3 1.5 2.0 3.4 2,6
Beta 0,9 1,1 1.1 0,9 1.0 1.1 1,0
Capitalization 1077934,3 7781251,4 2175377,6 443672,8 7135774,4 370761.8 273268,5
N 11,7 21,3 14.6 9.1 19,5 12,1 5,7
Return P3(high) 0.03325 0.02982 0.03146 0.02224 0.03272 0.02423 0.02906
1,6 1,7 4.3 2,5 3,1 1.3 2,1
Turnover 0.09033 0.09584 0.01689 0.00980 0.06878 0.07645 0.03545
P/E 20,9 7,3 12,7 16,9 7,8 23,8 17,9
P/BV 1,5 0,9 4.2 1,4 1.7 2,1 2,0
Beta 1,0 1,3 1,1 0,9 1.1 1.4 1,2
Capitalization 551381,8 6903783,2 1733531,2 265490,0 5713541,2 43165,2 236532,8
N 8,5 16,1 10,6 6.6 14,4 8,8 4,5
Return P1-P3 -0.00426 -0.01539 -0.01096 -0.01033 -0.00105 -0.02176 -0.01972
StdAbw 0,1 0.1 0,1 0,1 0,3 0.1 0,1
t -0,4 -1,3 -2.1 -1.5 -0,1 -1.5 -1.9

Panel B: Returns of Equally-Weighted Portfolios

Venezuel
Argentina Brazii Chile (Colombia IMexico Peru a

Return P1-P3 0.01497 0.00338 -0.00506 -0.01315 0.00170 -0.01277 -0.01051

StdAbw 0,2 0,1 0.1 0.1 0,1 0,1 0.1
t 0.9 0.4 -1,2 -1.7 0,2 -1.1 -1.1
Return PI 0.04220 0.02594 0.02244 0.01126 0.03167 -0.00135 0.01817
StdAbw 0,3 0,2 0,1 0.1 0,1 0,1 0.1
t 2,1 1,8 3.3 1.4 3.2 -0.1 1.5
Return P2 0.03956 0.02842 0.02345 0.01369 0.02726 -0.00399 0.00963
StdAbw 0,3 0,2 0,1 0.1 0.1 0,1 0.2
t 2.0 1.8 3,4 1.8 2.7 -0,3 0.8
Return PS 0.03390 0.02256 0.02750 0.02441 0.02996 0.01142 0.02869
StdAbw 0,3 0,2 0,1 0,1 0,1 0,1 0,2
t 1,6 1,3 3,9 2.8 2,8 0.6 2,1

Value-weighted monthly returns ( t in parenthesis), price-to-eamings (P/E) ratios, market price-to-book

price (P/BV) ratios, and Turnover (TO) for portfolios sorted every month by turnover. The modified
Scholes-Williams jS and the market capitalization for each portfolio are reported. The market capitaliza-
tion is expressed in millions of U.S. dollars, t is the value weighted mean return to its standard error. N
denotes the average number of stocks in each portfolio. Returns of equally weighted portfolios are pre-
sented in the last part.

118
Portfolios Sorted by Turnover

The goal of this section is to test whether variabiUty in trading activity explains the
cross-sectional expected return, i.e., to investigate whether less liquid stocks offer
higher returns than more liquid stocks.

In Table 4.8 the portfolios are sorted by turnover. According to the results of value-
weighted returns, in none of the Latin American stock markets is there a turnover ef-
fect. Completely contrary to what we expected, five market portfolios with the lowest
turnover (PI) have the lowest average returns and the highest J3. Furthermore, the
much higher returns of the most traded stocks (PS) are significantly different from the
returns of the less traded stocks (Pi) at a 5% level in Chile and Venezuela. In Chile
the y^ difference between PI and P3 is so small (0.06) that it might not to be sufficient
to explain the return difference between both portfolios (1.1%).

The average returns of equally weighted portfolios show slightly different results. The
sign and r-statistic of the return difference (P1-P3) change for some markets. The
r-value for Colombia increases and becomes significant at a 10% level. The opposite
happens in the case of Chile and Venezuela.

[Link] Different Periods

As was just seen in the previous section, our results do not confirm those obtained by
Rouwenhorst (1999), although we use similar data. Given the high volatility of
emerging market returns, a bit different time period might have different factors driv-
ing cross-sectional expected stock returns. Therefore, we want to test, if the results
obtained by Rouwenhorst (1999), specially for the Argentine and Mexican market,
were a period effect. In this section equally and value-weighted returns of three dif-
ferent periods are computed: (1) from the beginning^^ to November 1999 (whole pe-
riod), (2) from beginning to April 1997 (period of Rouwenhorst (1999)), and (3) from
May 1997 to November 1999. For each period stocks are sorted by 5, P/BV, P/E, or
TO and grouped into three portfolios. Then equally and value-weighted returns are
computed and each period is tested for the existence of market anomalies. Finally, we
examine whether the market anomalies vary among the different periods.

119
The obtained results are conclusive. Firstly, the results obtained here for the Rouwen-
horst's period are the same with his results. Secondly, as in section [Link] above, re-
turns of equally and value-weighted portfolios do not coincide. And thirdly, in most of
the markets the statistical significance of the anomalies vary with the time period (see
Table 4.9).

Contrary to the time period analyzed in the previous section, for the periods from
January 1982 to November 1999, January 1982 to April 1997, and May 1997 to No-
vember 1999, we found significant size effects in four of the stock markets (in Argen-
tina for the second period and a negative size effect for the third period, in Brazil for
the first and second periods, in Colombia for the third period, in Mexico for the first
and second periods, and in Venezuela a negative size effect for the third period). In-
terestingly, in the stock market where the size effect is statistically significant for the
second period, during the third period it disappears some times or even becomes nega-
live.""

As in the final section, Brazil, Chile, and Mexico have a statistically significant P/EV
effect for all analyzed periods (except for the third period in Chile). Precisely these
three countries and Argentina have the most reliable accounting systems of the region
(see Chapter 2). On the contrary, the significance of the P/E effect depends on the pe-
riod analyzed. For example, Chile has a significant P/E effect for the second period;
however, it becomes non-significant during the third period. Finally, the turnover ef-
fect also changes from period to period. In Colombia, Peru, and Venezuela there are
some periods for which there is a significantly negative turnover effect. However, this
result might be offset by the fact that these three markets have the lowest value-traded
for each period.

[Link] Portfolios Sorted Monthly and Yearly

Another possible reason for the different results obtained by researchers (Claessens et
al. (1996), Rouwenhorst (1999), and Hawawini and Keim (2(XX)), among others) is
the frequency at which they sort stocks. It is common practice to sort stocks annually
or monthly. A theoretical explanation does not exist for doing so. The main reason for

^^ Date at which the IPC begins to collect information for the corresponding stock market.
*^^ During the second half of the '90s most Latin American countries were in crisis. Therefore, inves-
tors tended to buy "big stocks," which are supposed to be better diversified.

120
Table 4.9: Summary Statistics for Different Periods

Equally- Value-
Weighted Weighted
PI P2 P3 PI -P3 t PI P2 P3 PI -P3 t

Argentina 84.01-99.11 0,05 0,05 0,04 0,02 1,30 0,04 0,05 0,04 0,01 0,53
84.01-97.04 0,07 0,06 0,04 0,03 1,70 0,06 0,06 0,04 0,01 1,23
97.05-99.11 -0,02 0,00 0,01 -0,03 -2,11 -0,03 -0,01 0,01 -0,04 -3,14
Brazil 82.01 -99.11 0,04 0,04 0,02 0,02 1,69 0,04 0,04 0,02 0,02 1,39
82.01 - 97.04 0,05 0,05 0,02 0,02 1,60 0,04 0,04 0,02 0,02 1,38
97.05-99.11 0,01 0,01 0,00 0,01 0,62 0,01 0,00 0,00 0,00 0,23
Chile 82.01 -99.11 0,02 0,02 0,02 0,00 0,62 0,02 0,02 0,02 0,00 0,84
82.01 - 97.04 0,02 0,02 0,02 0,00 0,65 0,02 0,02 0,02 0,00 0,81
97.04-99.11 0,00 0,00 0,00 0,00 0,01 0,00 0,00 0,00 0,00 0,23
Colombia 86.01 -99.11 0,02 0,02 0,02 0,00 -0,03 0,02 0,02 0,02 0,00 -0,71
86.01 - 97.04 0,03 0,03 0,03 -0,01 -0,81 0,02 0,03 0,03 -0,01 -1,09
97.05-99.11 0,00 0,00 -0,03 0,03 2,70 -0,01 -0,01 -0,02 0,01 1,36
Mexico 82.01 -99.11 0,04 0,02 0,02 0,02 2,20 0,04 0,02 0,02 0,02 2,24
82.01 - 97.04 0,05 0,02 0,02 0,02 2,47 0,04 0,02 0,02 0,02 2,24
97.05-99.11 0,01 0,00 0,02 -0,01 -0,98 0,00 0,00 0,02 -0,02 -1,94
Peru 95.01 -99.11 0,00 0,00 0,00 0,00 -0,14 0,00 0,00 0,01 -0,01 -0,74

97.05-99.11 0,00 0,00 0,00 0,00 0,12 0,00 -0,01 0,00 0,00 -0,04
Venezuela 86.01 -99.11 0,02 0,02 0,02 0,00 0,22 0,02 0,02 0,02 0,00 0,39
0,03 0,03 0,03 0,01 0,94 0,03 0,03 0,02 0,01 1,34
97.05-99.11 -0,02 -0,02 0,01 -0,03 -1,40 -0,03 -0,03 0,00 -0,04 -1,96

Panel B: Portfolios sorted by P/BV

Argentina 86.05-99.11 0,05 0,04 0,03 0,02 1,33 0,03 0,04 0,04 -0,01 -0,64
87.01 - 97.04 0,08 0,05 0,05 0,03 1,38 0,05 0,05 0,05 0,00 -0,34
97.05-99.11 -0,01 0,00 -0,01 0,00 -0,31 -0,01 0,02 0,01 -0,01 -1,05
Brazil 86.05-99.11 0,05 0,02 0,01 0,03 2,97 0,03 0,03 0,01 0,03 2,31
87.01 - 97.04 0,06 0,03 0,02 0,04 2,52 0,05 0,04 0,01 0,04 2,56
97.05-99.11 0,03 0,01 -0,01 0,03 2,40 0,01 0,01 0,00 0,01 0,43
Chile 86.05-99.11 0,03 0,02 0,02 0,01 2,43 0,03 0,03 0,02 0,01 2,12
88.01 - 97.04 0,03 0,02 0,02 0,01 2,11 0,03 0,03 0,02 0,01 1,54
97.05-99.11 0,00 0,00 0,00 0,00 0,10 0,00 0,00 -0,01 0,01 0,70
Colombia 87.01 - 97.04 0,01 0,02 0,01 0,00 0,55 0,01 0,02 0,01 0,00 0,46
87.01 - 97.04 0,01 0,03 0,02 -0,01 -0,72 0,02 0,03 0,02 -0,01 -0,56
97.05-99.11 0,02 -0,01 -0,03 0,04 2,55 0,01 -0,01 -0,03 0,04 2,01
Mexico 86.05-99.11 0,04 0,03 0,02 0,02 2,16 0,04 0,03 0,02 0,01 1,53
87.01 - 97.04 0,04 0,03 0,02 0,01 1,57 0,03 0,03 0,02 0,01 1,07
97.05-99.11 0,01 0,00 0,01 0,00 2,60 0,02 0,02 0,02 0,00 0,20
Peru 95.01 -99.11 0,00 0,01 0,00 0,00 0,06 0,00 0,01 0,00 -0,01 -0,42
95.01 - 97.04 0,00 0,01 0,00 0,00 0,01 0,00 0,01 0,01 -0,01 -0,33
97.05-99.11 0,00 0,00 0,00 0,00 0,08 -0,01 0,00 0,00 0,00 -0,25
Venezuela87.02-99.11 0,02 0,02 0,01 0,01 0,74 0,04 0,02 0,02 0,01 1,05
87.02 - 97.04 0,03 0,03 0,02 0,01 0.85 0,04 0,02 0,02 0,02 1.24
97.05-99.11 -0,02 -0,01 -0,01 0,00 -0,19 -0,02 0,00 -0,01 -0,01 -0,65

121
 P/E
Equally- Value-
Weighted Weighted
PI P2 P3 PI -P3 t PI P2 P3 PI -P3 t

Argentina 87.01 -99.11 0,05 0,04 0.03 0,02 1,46 0,05 0,04 0,04 0,01 1,21
87.01 - 97.04 0,07 0,05 0,04 0,02 1,38 0,06 0,05 0,04 0,02 1,46
97.05-99.11 0,00 0,00 -0,01 0,01 0,63 0,00 0,01 0,00 -0,01 -0,80
Brazil 87.01 -99.11 0,04 0,03 0,01 0,03 3,08 0,04 0,03 0,01 0,03 2,67
87.01 - 97.04 0,04 0,04 0,02 0,03 2,36 0,04 0,04 0,02 0,03 2,02
97.05-99.11 0,03 0,00 0,00 0,04 1,80 0,04 0,00 0,00 0,04 1,77
Chile 87.01 -99.11 0,01 0,01 3,21 0,02 0,03 0,01 0,01 1,78
87.01 - 97.04 0,03 0,02 0,01 1,62 0,02 0,03 0,02 0,00 0,49
97.05-99.11 0,01 0,00 -0,01 0,01 1,19 0,00 0,01 -0,01 0,01 1,29
Colombia 87.01 -99.11 0,02 0,02 0,01 0,01 1,62 0,02 0,02 0,01 0,01 1,09
87.01 - 97.04 0,02 0,03 0,02 0,00 0,50 0,03 0,03 0,02 0,00 0,48
97.05-99.11 0,02 -0,01 -0,03 0,04 2,34 0,00 -0,02 -0,03 0,03 1,25
Mexico 87.01 -99.11 0,04 0,02 0,02 0,02 3,56 0,04 0,03 0,02 0,02 2,75
87.01 - 97.04 0,04 0,03 0,02 0,03 3,27 0,04 0,03 0,02 0,02 2,47
97.05-99.11 0,03 0,00 0,01 0,02 1,63 0,03 0,03 0,01 0,02 1,51
Peru 95.01 -99.11 0,00 0,01 -0,01 0,01 1,41 0,00 0,01 0,00 0,01 0,69
95.01 - 97.04 0,01 0,01 -0,01 0,02 1,67 0,01 0,01 0,01 -0,01 -0,56
97.04-99.11 0,00 0,01 -0,01 0,01 0,65 0,00 0,01 -0,02 0,02 1,12
Venezuela 87.02-99.11 0,04 0,01 0,00 0,04 4,18 0,11 0,04 0,01 0,11 2,33
87.02 - 97.04 0,05 0,02 0,01 0,04 3,89 0,04 0,01 0,00 0,02 1,45
97.05-99.11 0,00 0,00 -0,03 0,03 1,60 0,39 0,16 0,02 0,54 2,32

Panel D: Portfolios sorted by TO

Argentina 87.01 -99.11 0,05 0,05 0,04 0,01 0,85 0,03 0,05 0,04 -0,01 -0,59
87.01 - 97.04 0,07 0,06 0,05 0,02 0,93 0,04 0,05 0,05 0,00 -0,30
97.05-99.11 -0,03 -0,02 -0,02 0,00 -0,38 -0,01 0,01 0,01 -0,02 -1,30
Brazil 87.01 -99.11 0,03 0,03 0,03 0,01 0,62 0,02 0,02 0,03 -0,01 -1,18
87.01 - 97.04 0,04 0,04 0,03 0,01 1,02 0,03 0,03 0,04 -0,01 -0,98
97.05-99.11 0,00 0,01 0,01 -0,02 -1,41 -0,01 0,01 0,01 -0,01 -0,72
Chile 87.01 -99.11 0,02 0,02 0,02 0,00 -0,32 0,02 0,02 0,03 -0,01 -1,37
87.01 - 97.04 0,03 0,02 0,03 0,00 0,27 0,03 0,03 0,03 -0,01 -1,23
97.05-99.11 -0,01 0,01 0,00 -0,01 -1,19 -0,01 0,00 0,00 -0,01 -0,59
Colombia 87.01 -99.11 0,01 0,01 0,02 -0,01 -1,71 0,01 0,02 0,02 -0,01 -1,49
87.01 - 97.04 0,02 0,02 0,03 -0,01 -1,24 0,02 0,03 0,03 -0,01 -1,04
97.05-99.11 -0,02-0,01 0,01 -0,03 -1,26 -0,03 -0,02 -0,01 -0,02 -1,18
Mexico 87.01 -99.11 0,03 0,02 0,03 0,00 0,07 0,03 0,02 0,03 0,00 0,16
87.01 - 97.04 0,03 0,03 0,03 0,00 0,58 0,03 0,03 0,03 0,00 0,64
97.05-99.11 0,00 0,01 0,02 -0,02 -1,24 0,01 0,01 0,02 -0,01 -1,02
Peru 95.01 -99.11 0,00 0,00 0,01 -0,01 -1,12 0,00 0,00 0,02 -0,02 -1,47
95.01 - 97.04 0,00 0,00 0,02 -0,02 -2,05 0,02 0,01 0,02 0,00 0,17
97.04-99.11 0,00 -0,01 0,00 0,00 -0,14 -0,01 -0,01 0,03 -0,04 -1.72
Venezuela 87.02-99.11 0,02 0,01 0,03 -0,01 -1,06 0,01 0,02 0,03 -0,02 -1,91
87.02 - 97.04 0,02 0,02 0,04 -0,02 -1,31 0,02 0,02 0,03 -0,02 -1,63
97.05-99.11 0,00 -0,03 -0,01 0,01 0,45 -0,01 0,01 0,01 -0,02 -1,09
The equally- and value-weighted returns of portfolios sorted by S, P/BV, P/E, and TO are reported.
The portfolios are the same as those of tables 5, 6, 7, and 8. The first period corresponds to the period
in which information is available. The second is the period analysed by Rouwenhorst (2000) and the
third period starts from the last observation of Period 2 to the last observation available in our data
sample.

122
sorting stocks monthly is the fast changing environment in the emerging markets. On
the other hand, trading costs used to be higher in emerging markets and sorting stocks
once per year was sufficient. In addition, sorting stock once per year helps to confirm
or reject the results documented by Claessens et al. (1996).

Without deciding which sort frequency is the correct one, we sort stocks monthly and
annually according to their S, P/BV, P/E, and TO. Then equally and value-weighted
returns are computed. Finally, we test whether market anomalies are significant and
how they vary between stocks sorted on a monthly or yearly basis.

The results of monthly and yearly sorted portfolios are shown in Table 4.10. In Panel
A, the results of size-sorted stocks are reported. As the r-test shows, for equally
weighted portfolios the return difference of monthly sorted stocks was significant only
in one additional portfolio, which did not have a significant size effect with annually
sorted stocks. The same result was obtained for value-weighted portfolios. Panels B
and D show similar results for stocks sorted by P/BV and TO. By stocks sorted by
P/BV, the return difference is statistically significant for monthly sorted portfolios
only in one additional stock market, where yearly sorted stocks were not significant.
The same holds for portfolios with stocks sorted by TO. Only portfolios sorted by P/E
show a different result (see Panel C). For portfolios sorted by P/E, the return differ-
ence {P1-P3) was always higher when stock were sorted monthly,^^ and it was sig-
nificant in four markets whereas yearly sorted stocks were not.

4.7.2 6-Portfolio Approach

The different number of portfolios used by researchers could also be another source of
divergent results. For example, Rouwenhorst (1999) groups stocks into three portfo-
lios, Claessens et al. (1996) into four, and Herrera and Lockwood (1994) into six. To
determine whether the number of portfolios influences the results, we test here for the
four anomalies using six portfolios. Stocks are ordered according to 5, P/BV, P/E, or
TO, and then are grouped into six portfolios. Monthly equally weighted returns are

^^ Furthermore, the standard deviation of monthly sorted portfohos tends to be lower. For the Mexican
market, e.g., the standard deviation of size-sorted portfolios is 1.1084 for equally and 0.1180 for value-
weighted stocks. These standard deviations are larger than those of the monthly sorted portfolios (see
Tables).

123
computed for each of the six portfoUos and the return difference (P1-P6) is computed
for each month from May 1986 to November 1999.

Table 4.10: Summary Statistics for Portfolios Sorted on a Monthly or Yearly

Basis

P1 P2 P3 P1-P3 t P1 P2 P3 P1-P3 t

Panel A: Returns
1 of Portfolios Sorted Yearly or Monthly by Size
Argentina YS 0,051 0,047 0,039 0,012 0,740 0,037 0,042 0,039 -0,002 -0,197
MS 0,054 0,047 0,035 0,019 1,304 0,042 0,046 0,037 0,005 0,532
Brazil YS 0,041 0,036 0,027 0,013 1,038 0,039 0,033 0,028 0,010 0,720
MS 0,042 0,041 0,021 0,021 1,691 0,038 0,039 0,021 0,018 1,395
Chile YS 0,019 0,018 0,016 0,003 0,580 0,091 0,018 0,015 0,076 1,024
MS 0,020 0,017 0,017 0,003 0,615 0,020 0,016 0,016 0,004 0,840
Colombia YS 0,024 0,024 0,021 0,003 0,411 0,018 0,024 0,021 -0,003 -0,462
MS 0,022 0,025 0,022 0,000 -0,032 0,017 0,024 0,021 -0,005 -0,714
Mexico YS 0,036 0,023 0,023 0,013 1,622 0,031 0,022 0,021 0,010 1,316
MS 0,040 0,020 0,023 0,018 2,196 0,039 0,022 0,022 0,017 2,239
Peru YS 0,006 -0,003 0,006 0,000 -0,037 0,003 -0,005 0,006 -0,004 -0,337
MS 0,003 0,000 0,004 -0,002 -0,145 -0,001 0,002 0,006 -0,007 -0,735
Venezuela YS 0,022 0,021 0,020 0,002 0,207 0,023 0,021 0,020 0,002 0,256
MS 0,024 0,018 0,022 0,002 0,222 0,022 0,018 0,019 0,003 0,386

Panel B: Returns of Portfolios Sorted Yearly or Monthly by P/BV

Argentina YS 0,045 0,040 0,054 -0,009 -0,510 0,032 0,042 0,042 -0,011 -1,100
MS 0,059 0,043 0,036 0,023 1,317 0,036 0,043 0,042 0,002 0,239
Brazil YS 0,049 0,022 0,017 0,032 2,640 0,041 0,026 0,018 0,024 1,925
MS 0,051 0,025 0,015 0,035 3,056 0,041 0,034 0,010 0,031 2,555
Chile YS 0,024 0,020 0,016 0,007 1,350 0,025 0,021 0,018 0,007 1,373
MS 0,030 0,019 0,017 0,013 2,663 0,029 0,024 0,018 0,012 2,305
Colombia YS 0,017 0,022 0,011 0,007 0,752 0,018 0,021 0,010 0,007 0,863
MS 0,013 0,024 0,009 0,004 0,552 0,015 0,024 0,011 0,004 0,456
Mexico YS 0,028 0,025 0,023 0,004 0,573 0.023 0,027 0,023 0,000 -0,035
MS 0,033 0,022 0,021 0,012 1,578 0,031 0,025 0,023 0,008 1,067
Peru YS 0,004 0,003 -0,001 0,004 0,485 -0,004 0,010 0,005 -0,010 -0,898
MS 0,001 0,005 0,000 0,001 0,063 -0,003 0,008 0,004 -0,006 -0,425
Venezuela YS 0,016 0,022 0,009 0,007 0,710 0,012 0,021 0,006 0,007 0,611
MS 0,018 0,018 0,013 0,004 0,217 0,022 0,018 0,013 0,010 0,403

Panel C: Returns on Portfolios Sorted Yearly or Monthly by P/E

Argentina YS 0,05 0,0391 0,0435 0,007 0,6119 0,0534 0,038 0,039 0,014 1,1668
MS 0,0533 0,0394 0,0335 0,020 1,4608 0,0472 0,0438 0,036 0,011 1,2137
Brazil YS 0,0302
0,0197 0,024 0,006 0,6299 0,026 0,0217 0,028 -0,002 -0,142
MS 0,0415
0,0289 0,0131 0,028 3,0792 0,044 0,0311 0,013 0,031 2,6737
Chile YS 0,0226
0,0212 0,0161 0,007 1,264 0,0227 0,0235 0,014 0,009 1,5866
MS 0,0271
0,0249 0,0127 0,014 3,2101 0,0219 0,0271 0,013 0,009 1,7767
Colombia YS 0,0154
0,0143 0,0236 -0,009 -1,18 0,0183 0,0173 0,018 0,000 0,0544
MS 0,0191
0,0219 0,0108 0,011 1,6177 0,0215 0,0178 0,012 0,010 1,0929
Mexico YS 0,0333
0,0243 0,0249 0,008 1,3174 0,0322 0,0282 0,022 0,010 1,6245
MS 0,0405
0,025 0,0159 0,025 3,5568 0,0351 0,03 0,017 0,018 2,7482
Peru YS 0,0014
0,0063 -0,009 0,010 1,3467 -0,005 0,0099 0,007 -0,012 -0,81
MS 0,0022
0,0096 -0,011 0,013 1,4101 0,0043 0,0095 -0,004 0,008 0,6877
Venezuela YS 0,0312 0,0123 0,002 0,029 3,0387 0,0309 0,0089 0,008 0,023 2,1153
MS 0,0412 0,0121 0,0002 0,041 4,202 0,0416 0,0117 0,005 0,037 3,4028

124
 P1 P2 P3 PII-P3 t PI P2 P3 P1-P3 t

Panel D:Returns of Portfolios Sorted Yearly or Monthly by TO

Argentina YS 0,060 0,041 0,039 0,021 1,220 0,040 0,042 0,039 0,000 0.041
MS 0,053 0,046 0,038 0,015 0,852 0,032 0,046 0,038 -0,006 -0.589
Brazil YS 0.032 0,028 0,023 0,009 0,993 0,020 0,027 0.028 -0,007 -0,588
MS 0,031 0,031 0,026 0,005 0,619 0,019 0,023 0,033 -0,014 -1,178
Chile YS 0,019 0,018 0,023 -0,004 -0,849 0,015 0,017 0.028 -0,013 -2,434
MS 0,022 0,020 0,023 -0,001 -0,316 0,020 0,021 0,027 -0,007 -1,366
Colombia YS 0,019 0,017 0,015 0,003 0,394 0,016 0,021 0,018 -0,002 -0,232
MS 0,011 0,014 0,024 -0,013 -1,714 0,012 0,019 0,022 -0,010 -1,493
Mexico YS 0,028 0,025 0,023 0,004 0,573 0,023 0,027 0,023 0,000 -0.035
MS 0,026 0,024 0,026 0,001 0,072 0,029 0,024 0,028 0,001 0.158
Peru YS -0,005 0,003 0,006 -0,010 -1,022 0,004 0,012 0,023 -0.019 -1.366
MS -0,001 -0,004 0,011 -0,013 -1,120 0,002 0,001 0,024 -0.022 -1,469
Venezuela YS o,oo6 o,oi4 o,028 -0,022 -2,258 0,003 0,015 0,027 -0,025 -2,330
MS 0,014 0.009 0,029 -0.015 -1,508 0.006 0,016 0.028 -0,022 -2,046
The monthly returns on portfolios sorted once per month (MS) or year (YS) are reported. The portfolios
are the same as those in Tables 5, 6, 7, and 8. The sample periods are the first periods reported in Table
4.9.

Finally, with a Mest, we examine whether the difference is statistically significant and
compare the results with those of the 3-portfolio analysis. Due to the small number of
stocks included in the database for most of the LAEM, six portfolios can only be con-
structed for Brazil and Mexico.

The results are shown in Table 4.11. The average of the return differences (P1-P6)
are a little bit higher than the return differences of section [Link] for three of the four
variables, TO is the exception. These small changes of the return differences {PI -P6)
do not modify the results of the 3-portfolio approach: the registered anomalies for
Brazil and Mexico are P/BV and P/E. However, these results were expected since the
S-, P/BV-, P/E-, and TO-Variation among the portfolios was already large enough in
the 3- portfolio approach. For example, in Brazil the average size of the largest portfo-
lio of the 3-portfolio approach was 122 times larger than the smallest portfolio. In the
6-portfolio approach it increases to 334.

4.8 Conclusions
We had two goals in this chapter. Using a portfolio approach, we investigated whether
firm size, price-to-book value, price-to-eamings, and turnover influence the expected
returns as they do in the developed markets. At the same time, we sought an explana-
tion of the contradictory results obtained by Rouwenhorst (1999) and Claessens et al.
(1995). To achieve these objectives, test of significance for these anomahes were car-

125
ried out for different periods, for different ways of grouping and weighting stocks, and
different ways of computing returns. The information for the seven stock markets ana-
lyzed (Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela) has been
taken from the EMDB of the IFC-S&P.

Table 4.11: Summary Statistics for the 6-Portfolio Approacli

PO P1 P2 P3 P4 P5 P6 PI - P 6
Panel A) Brazil
Size 86.05-99.11 3,9 1,0 3,9 2,9 2,5 2,2 1,7
(2.0) (0.6) (2.3) (1.7) (1.6) (1.5) (1.2)
P/BV 86.05-99.11 5,8 3,2 3,0 1,1 1,6 0,7 5,1
(2.7) (1.8) (1.8) (0.7) (1.1) (0.5) (3.2)
P/E 86.05-99.11 2,300 3,7 3,5 2,9 2,5 1,5 0,6 3,1
(1.5) (1.9) (2.7) (1.8) (1.5) (0.9) (0.5) (2.2)
TO 86.05-99.11 2,5 2,8 2,4 3,4 1,5 2,7 -0,2
.iL6) ^^ (2.0) (1-5) (-0.2)
Panel B) Mexico
Size 86.05-99.11 3,9 2,1 2,1 2,6 3,1 2,8 1,1
(3.0) (2.3) (2.1) (2.7) (3.2) (2.6) (1.1)
P/BV 86.05-99.11 4,0 3,5 2,9 2,6 2,4 2,1 1,9
(3.0) (3.2) (2.9) (2.6) (2.3) (2.3) (1.9)
P/E 86.05-99.11 0,0 5,0 3,4 3,2 2,8 2,7 1.5 3,5
0,0 (3.7) (3.0) (3.0) (2.8) (2.9) (1.6) (3.6)
TO 86.05-99.11 2,8 3,2 2,6 3,0 2,7 3,1 -0,3
(2.5) (3.1) (2.5) (2-9)
The stocks are grouped in 6 equally-weighted portfolios, which are rebalance each month according to
one of the four variables (S, P/BV, P/E or TO). The monthly return are computed for each portfolio us-
ing different time periods. The numbers in parenthesis correspond to the /-test.

Before the anomalies were tested, the stock return characteristics of the LAEM were
analyzed. We found that the market capitalization and number of quoted firms was
much smaller in the LAEM than in the developed stock markets. However, the weight
of the LAEM on the total market capitalization of the IFCG Composite Index was
22% at the end of 1999. We also documented that the returns of these stock markets
have (1) high mean returns with high standard deviations, (2) a greater autocorrelation
than in the developed markets, (3) a non-normal distribution (except Chile), and (4) a
low cross-country correlation, which increased in the '90s. These characteristics dif-
ferentiate the LAEM from the developed markets.

The portfolio approach has revealed some important results. From Table 4.12 one can
see that the result varies (1) from country to country, (2) from period to period, (3)
depending on the frequency stocks are sorted, i.e., monthly or yearly, and (4) depend-

126
ing on the way stocks are weighted, i.e., equally or value-weighted. The only variable
that may not influence the results is the number of portfolios into which stocks are
sorted. In view of these results, it may not be at all correct to say that anomalies exists
in a LAEM. However, there were two exceptions to this: we found a significant P/BV
effect in Brazil and a P/E effect in Mexico. And it is precisely Brazil and Mexico,
along with Chile, that have the best-rated accounting systems in the region (see Chap-
ter 2).

It is easier to say with greater accuracy where there are no anomalies. According to
Table 4.12, the size was never significant in Chile, Peru, and Venezuela. P/BV was
never significant in Argentina, Peru, and Venezuela, while the P/E never was in Peru.
And, finally, we documented a significant turnover effect in any market. From the re-
sults it is possible to recognise that investors might generally want to take account of
the P/BV and P/E only if the country has reliable accounting standards.

A multivariate analysis is carried out in the next section. This analysis promised to
shed light on the impact of P and of the several fundamental variables on average
stock returns. To do it, it is necessary to test whether the differences in P are enough
to explain the return differences between the portfolios. For example, the portfolios
PI sorted by E/P in Brazil and Chile offer the highest returns, but the y^of these port-
folios is larger than the P of portfolios P3. This fact gives rise to the following ques-
tions: Would y^ be able to absorb the return variation (which is apparently influenced
by P/E) so that P/E becomes insignificant, even if the differences in P are small? Or
could it do so even if P/E but not P were still significant, or if both of them were sig-
nificant, or would a third factor perhaps be required as well? In the next chapter, a
one-factor model (also known as CAPM) and then two- and three-factor models will
be tested.

127
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128
6 Conclusions
Before participating in a stock market, investors compare it with others. In the Htera-
ture three factors are often considered important for the comparison: stock returns,
their associated risk, and cost of trading. Accordingly, in the forgoing we have studied
three questions with regard to the seven major Latin American stock markets: (1)
How different are the financial, economic, and political conditions of the LAEM from
the developed markets and what are the investment laws in the LAEM? (2) What is
the cost of trading in the LAEM; is it higher than in the developed stock markets?
And (3) does the return determination process in the LAEM differ from those proc-
esses documented for the developed markets? The first and second questions were
studied in the first part of this thesis (Chapters 2 and 3), while the third question was
addressed in the second part (Chapters 4 and 5).

The seven emerging markets of Latin America studied here were Argentina, Brazil,
Chile, Colombia, Mexico, Peru, and Venezuela. They were selected in accordance
with the IFC-S&P's definition of emerging markets. Although the seven major Latin
American emerging markets fulfill the IFC-S&P requirements, they are nevertheless
heterogeneous. Areas such as operational efficiency, quality of market regulation, su-
pervision and enforcement, corporate governance practices, minority shareholder
rights, transparency, level of accounting standards, and information levels vary sub-
stantially across these stock markets (see 2.5 above).

The emerging markets are gaining in importance. Capital flows to the emerging stock
markets, especially to Asia and Latin America, increased substantially in recent years
(see 2.3). The interest of researchers in emerging markets has also increased; how-
ever, investigations analyzing stock returns, their associated risk and cost of trading,
are still limited.

In Chapter 2 the analyzed Latin American stock markets are introduced. The presenta-
tion centers on two questions: (1) What are the financial, economic, and political con-
ditions in those countries? And (2) what are the investment laws there? Financial,
economic, and political conditions are important aspects of a stock market since they
influence the associated risk of stock returns. The first question is discussed through
the political, economic, financial, and compounded risk indexes of the ICRG. To an-
swer the second question, the Investment Law Index is developed and calculated.

158
In contrast to developed countries, political risk is more important in emerging mar-
kets. In developed countries, economic news is likely to have a more significant im-
pact on the stock market than political news since the impact of the latter is less clear
(Chan, Chui, and Kwok (1999)). However, the evidence shows the reverse in emerg-
ing markets. The ICRG considers political risk to be twice as important as economic
and financial risk because it is related to the intention to pay, while economic and fi-
nancial risk is associated with the ability to pay. The political events in Latin America
over the past two decades have confirmed the ICRG's position.

The political index shows great heterogeneity among the Latin American countries
(see 2.4). Compared to developed countries (France, Germany, the UK, and the U.S.),
the political risk of the LAEM is higher. However, most of the LAEM showed greater
improvements than the developed markets did. Although the magnitudes differ, the
LAEM showed an increase in the risk rating from 1986 to 1999.^^^ The countries with
the highest improvement were Chile and Peru, which had increases of 71% and 59%,
respectively. The 25% and 10% decreases of Venezuela and Colombia were the low-
est of the region. The political risk indexes of Brazil and Mexico were the most stable
of the LAEM and belonged among the highest over the whole analyzed period. The
political risk index of Argentina increased significantly in the first part of the '90s but
decreased strongly in 2001. The political correlation between the LAEM and devel-
oped countries is high. However, when the U.S. political risk index declines, the po-
litical indexes of the LAEM and other developed countries also diminish. The oppo-
site does not occur.

The economic risk ratings showed similar results regarding political risk. The rela-
tionship between stock returns and economic variables has been shown to be strong
(see, e.g., Fama (1990), Balvers et al. (1990), and Lovatt (1996)). Therefore, the eco-
nomic risk ratings of the ICGR were discussed in section 2.4. The economic risk rat-
ings summarize the macroeconomic factors (current account to GDP, real GDP
growth, inflation, budget balance to GDP, and GDP per capita). The trajectories of
economic and political risk ratings show some similarities. (1) Chile, Mexico, and
Peru have the lowest economic risk; (2) economic risk decreased during the analyzed
period in most of the LAEM, especially in Chile and Brazil. The decreases were more

^^^ A higher risk rating means less risk.

159
evident from 1990 to 1994. Thereafter, the risk ratings diminished (risk increased) as
a consequence of the crises in Mexico and Brazil. (3) Compared to developed mar-
kets, the LAEM have significantly lower economic risk ratings (i.e., are riskier); their
volatility is much higher and they show faster improvements.

The financial ratings, which aim to provide a measure of the countries' ability to pay,
shows that: (1) the financial risk diminished over the last 15 years, (2) the volatility of
the indexes vary significantly among the LAEM, (3) compared to the developed coun-
tries, the LAEM have a higher financial risk over the whole period. The financial risk
of the LAEM diminished at higher rates than in France, Germany, the UK, and the
U.S.

Using the Composite Risk Index, we aimed to answer two questions: (1) How risky
are the LAEM compared to the most developed stock markets? And (2) how different
is risk across the LAEM? The CRI is the weighted sum of political, financial, and
economic risk indexes (poUtical risk 50%, financial and economic risk each 25%).
The CRI shows that (1) the LAEM are riskier than the four developed countries, but
(2) in the LAEM risk diminished faster. (3) The LAEM are heterogeneous and can be
divided into two groups, the first group consisting of the least risky countries (Chile,
Mexico, and Colombia) and the second consisting of the riskiest countries (the riskiest
being Peru, which is followed by Argentina, Brazil, and Venezuela). And (4) the CRI
correlation between the LAEM is low but higher than with the U.S. or Germany.

An Investment Law Index was developed and calculated in the second part of Chapter
2 (section 2.5). The aim of the IL-Index is to determine the differences as regards (1)
shareholder rights, (2) law enforcement, (3) insider trading, and (4) investment barri-
ers to foreigners across the LAEM, and how they compare to some developed mar-
kets. Contrary to La Porta et. al. (1998),^^^ the information on the existing shareholder
rights, law enforcement, insider trading, and barriers to foreign investors was aggre-
gated into the IL-Index. An index makes it easier for investors to interpret the infor-
mation and compare it across countries.

They discussed in a separate way shareholder rights, law enforcement, and insider trading.

160
The IL-Index is calculated by averaging the values of the indexes on investor protec-
tion,^^^ law enforcement, insider trading, and barriers to foreign investors.^^'^The BL-
Index shows that the laws stimulating investments vary in the Latin American coun-
tries analyzed. They fall into two groups: Chile, Argentina, Brazil, and Peru have the
highest IL-Index, while Colombia, Mexico, and Venezuela have the lowest. Com-
pared to the developed markets, the IL-Index of the first group is as high as that of It-
aly, France, and Germany, but lower than that of the U.S. and the UK.

The presentation of the LAEM in Chapter 2 showed that: (1) the LAEM are heteroge-
neous but all are riskier than the developed countries and (2) investment incentives
and restrictions in the former substantially differ from developed markets. For these
reasons it is interesting to study whether the factors determining the stock returns in
the LAEM are similar to those determining returns in developed markets. This is stud-
ied in Chapters 4 and 5. But before turning to this topic, the implicit trading costs in
the LAEM is investigated in Chapter 3.

Studying the trading costs is important since it can influence (1) the composition of
globally efficient portfolios and (2) the international order flow (Domowitz et al.
2001). Trading a stock in one way costs 58 bp in Brazil and 61 bp in Mexico, while in
Colombia and Venezuela it costs 97.5 bp and 134 bp, respectively. Compared to de-
veloped marks, trading costs in the LAEM are high. For example, one-way trade in
Paris costs 29.5 bp, in Frankfurt 37.7 bp, in the U.S. 38.1 bp, and in London 54.5 bp.
The one-way average trading costs in the Latin American markets is 86.9 bp, while in
the four developed markets it is 40 bp. If these portfolios turn over twice per year, the
annual average trading costs will be 347.6 bp in the LAEM and 159.8 bp in the devel-
oped markets. These represent 16% of the average annual portfolio returns for the
LAEM and 12% for the developed markets.

In Chapter 3 we studied and compared the determinants of implicit trading costs

among the LAEM andfour developed markets. Specifically, the development state and
the trading architecture were analyzed since, according to the literature, they deter-

La Porta et al. (1998) developed an antidirector rights index. The difference between this index and
the SH-Index is that the SH-Index additionally includes mandatory dividends and the percentage of
capital to call an extraordinary shareholder meeting. By including these additional rights, the SH-
Indexes of French-civil-law countries move closer to conmion-law countries. However, the differences
are not important enough to have a significant impact on the IL-Index.

161
mine the implicit costs. Three questions were discussed in this chapter: (1) How het-
erogeneous are implicit trading costs among the LAEM? (2) How different are the
implicit trading costs in the LAEM from those in the developed markets? And (3)
which factors are responsible for the differences? To answer these questions, we de-
signed two main indexes: Development State Index and Trading Architecture Index.
With these indexes is possible to detect the factors responsible for the high trading
costs in the LAEM.

Since stock market development is a multifaceted concept, the DS-Index was calcu-
lated by averaging four market indicators: stock market size, liquidity, stock market
concentration, and number of quoted firms. The DS-Index shows that the LAEM are
heterogeneous (see Table 3.3). In Brazil, Chile, and Mexico the DS-Index tended to
be higher than in Argentina, Colombia, Peru, and Venezuela. Compared to developed
markets, the results show that the developed markets are more developed than the
LAEM. The DS-Index's components confirm the foregoing results. (1) Stock market
size is significantly lower in most Latin American markets. Of the LAEM, Chile is the
only stock market that has a MC/GDP comparable to Germany's. (2) VT/GDP and TO
vary across the Latin American markets. Compared to developed markets, the
VT/GDP ratio is also much lower in the LAEM. (3) Concentration is higher in the
LAEM. (4) The number of quoted firms also shows the heterogeneity of the LAEM
and a great difference from the developed markets. For example, among the Latin
American markets, Brazil has the highest number of quoted firms (486 in 1999),
which is a half of those in Germany and only 5% of the firms trading in the U.S.

The TA-Index was developed in section 3.4. By "trading architecture" we understand

the participating elements that make possible the trading process. The trading process
can be divided into three phases: the buying and selling of securities by means of in-
termediaries, the transmission of orders from intermediaries to the central order book,
and the clearing and settlement of securities and funds. In order to include the three
phases in the TA-Index, the Intermediary Index, the Trading System Index, and the
Custody, Clearing and Settlement Index were first calculated. Then the TA-Index is
obtained by means of these indexes. For each LAEM and the studied developed mar-

This way of weighting the components produce reasonable results. The method of weighting em-
ployed here is not discussed further in this thesis.

162
kets, the TA-, I-, TS-, and CCS-indexes are shown in Table 3.18. This table is also
shown below.

The participation of intermediaries is relevant for a trading system because they facili-
tate the transactions of stocks between buyers and sellers. In each LAEM, all of which
are order-driven, there are two types of intermediaries: brokerage firms or brokers and
market-makers. The introduction of market-makers in the LAEM is recent and is justi-
fied by the stock trading concentration in these markets. Since the functions (privi-
leges and obligations) of brokerage firms do not vary across the analyzed markets,
they are not included in the I-Index. For this reason, only the functions of market-
makers are taken into account. Demarchi and Foucault (1998) used four obligations
and three privileges to describe market-makers. The I-Index is computed using these
factors (see 3.4.1). The I-Index shows how the obligations and privileges of the mar-
ket-makers varies across the Latin American exchanges. Chile and Peru have the
highest index, followed by Brazil and Mexico. Colombia and Venezuela have the
lowest I-Index. The duties of market-makers in Chile and Peru are similar to the du-
ties of the animateurs of the Paris Bourse and, to a lesser extent, to those of the Be-
treuers of Frankfurt.

The next computed index was the Trading System Index. The TS-Index is important
because it influences the price discovery process, that is, transaction costs and risk.
The TS-Index is computed by averaging the points of market segmentation (types of
stock orders and segments of the stock market) and electronic trading system (func-
tions of the electronic trading systems, the use of call auctions, and information trans-
parency). In section 3.4.2 we described how the TS-Index is computed. Like the other
indexes, the TS-Index also shows the great heterogeneity in the LAEM. The trading
systems of Sao Paulo, Mexico, and Caracas have the highest TS-Index, while Colom-
bia and Lima have the lowest. Buenos Aires and Santiago are in the middle. Com-
pared to the trading systems of developed markets, the seven Latin American systems
have index ratings below the three developed markets analyzed. The reason for this
lies in the low trading segmentation of the LAEM, which may be caused by the small
number of stocks quoted. The limited opportunities for trading and the absence of
some functions of the ETS may increase trading costs, which in turn affects liquidity
and the cost of capital in Latin America.

163
The third and final component of the TA-Index is the Custody, Clearing, and Settle-
ment Index. The clearing and settlement phases, together with the custody phase,
seems to be merely administrative; however, problems can arise if one of the two par-
ties does not fulfill the contract. The CCS-Index is constructed using information on
its three components: custody (ownership structure, additional services, the form in
which records of ownership are held), clearing (trade capture, matching, confirmation,
comparison and affirmation mechanisms, and the calculation of settlement obliga-
tions), and settlement (delivery versus payment, settlement assurance, and settlement
time). In 3.4.3 we described each of these elements in detail. The TA-Index shows
that these trading phases are as risky in Buenos Aires, Sao Paulo, Mexico, and Cara-
cas as in Paris, Frankfurt, or New York. The process is riskier, however, in the Santi-
ago, Colombian, and Lima exchanges.

Finally, the TA-Index is computed by averaging the I-, TS-, and CCS-Indexes. The
TA-Index shows that there exists a great heterogeneity in the LAEM. According to
this index, Sao Paulo and Mexico have the most developed trading architecture among
the Latin American stock markets. Buenos Aires, Lima, Santiago, and Caracas follow,
while Colombia has the lowest TA-Index. Compared to the developed markets, the
TA-Index of all Latin American exchanges is significantly lower. Finally, the TA-In-
dex makes it clear that the factors responsible for the weaknesses of the Latin Ameri-
can trading architectures differ from market to market. Buenos Aires, Colombia, and
Caracas - and, to a lesser extent, Sao Paulo and Mexico - have to reinforce the role of
their market makers. The trading systems is particularly weak in Colombia and Lima.
Custody, clearing, and settlement is weak in Santiago, Lima, and Colombia.

According to the results of the designed indexes, the answers to the three guiding
questions read as follows: (1) The development states and trading architectures of the
LAEM differ among themselves. Of the LAEM, Brazil and Mexico have the highest
DS- and TA-Indexes. Chile has a high DS-Index, but its TA-Index is low. Both in-
dexes are lower in Argentina, Peru, Venezuela, and Colombia (in this order). Com-
pared to developed markets, both indexes show that (2) the implicit trading costs are
higher in all LAEM and that (3) the factors responsible for the higher costs differ
among them. In Table 6.1 the elements that each LAEM should improve in order to
diminish the implicit trading costs are marked with an X.

164
Table 6.1: Summary Results of Implicit Trading Costs

Argentina Brazil Chile Colombia Mexico Peru Venezuela

Implicit Trading Cost 29,6 21,4 38,6 42,2 27,3 35,2 34,7

DS-lndex
MC/GDP X X X X
Liquidity X X X X
Concentration X X X X
NQF X X X X

TA-lndex
l-lndex Privileges -- X X X X X
Obligations -- X X X
TS-lndex Segmentation X X X X
ETS X X X X
CCS-lndex Depository X X
Clearing X X X X
Settlement X X -- X --
X means that the stock market belongs to the last 4 of the LAEM or are under the
average
- - means no information

In concluding Chapter 3, the robustness of the indexes was shown. Table 3.19 shows
that the exchanges with the lowest implicit trading costs have the highest D- and TA-
Indexes. This reflects the importance of the selected components for each index and at
the same time gives a clue to how they are related to trading costs.

Chapter 4 had two main goals. The first was to investigate whether the factors ex-
plaining the return variation in the LAEM are similar to those documented in devel-
oped markets - specifically, whether the firm size and the ratios price-to-book value,
price-to-eamings, and the turnover, influence the expected returns. The second goal
was to reconcile the contradictory results of previous investigations that tested for
anomalies at a stock level in the Latin American markets. There are at least four rea-
sons why those studies came up with contradictory results: their different sample pe-
riods, different number of portfolios, different frequencies at which they sorted stocks,
and different methods for the computation of portfolio returns (equally or value-
weighted).

To achieve our goals, we conducted a simple portfolio approach. Thus we sorted

stocks by one of the variables into one of three or six portfolios, allocated the stocks

165
each month or year, and then calculated the returns either equally or value-weighted.
We also compared the results of different sample periods.

Chapter 4 was divided into five sections. The empirical evidence from developed and
emerging markets was presented in the first section. Of the existing literature on mar-
ket anomalies in emerging markets, the publications of Rouwenhorst (1999) and
Claessens et al. (1995) are of particular importance. It is their contradictory results
that have provided the impetus for this chapter. Rouwenhorst (1999) found that the re-
turn factors in emerging markets are similar to those documented for many developed
markets. By contrast, Claessens et al. (1995) demonstrated empirically that the Latin
American markets may have a size effect, but it is not necessarily restricted to the
smallest sized stocks. To study the reasons for the contradictory results, the EMDB of
the IFC-S&P is used and discussed in section 4.3. This database is employed because
it publishes current and historical statistics of series needed and has proved reliable.

Section 4.4 presents summary statistics of the LAEM, while 4.5 discusses some prop-
erties of the monthly returns. It is shown that (1) the average returns and standard de-
viation of the LAEM are often higher than in the developed markets and many other
emerging markets, (2) the mean and median are different, (3) the stock returns are not
normally distributed (except in the Chilean market), and (4) the cross-country return
correlation was low in the 1980s but increased in the '90s.

Before testing for the market anomalies in the LAEM, the univariate portfolio meth-
odology is described in 4.6. The portfolio approach involves four steps: (1) At the be-
ginning of each period (month or year), stocks are ranked according to one of the
variables (5, P/BV, P/E, or TO). (2) Stocks are grouped into one of the portfolios
(three or six). (3) For each portfolio, equally or value-weighted returns, its volatility,
and its average TO, P/E, P/BV, 5, and y^are computed. Finally, (4) we test whether the
return differences between the portfolios are statistically significant.

The results do not replicate the evidence of developed markets (see 4.7). For the sam-
ple period, from May 1986 to November 1999, value and equally monthly returns of
the 3-portfolio approach shows the following results: (1) For size-sorted portfolios,
the return differences between PI and P3 are significantly different from zero in any
stock market. One possible reason for the absence of a size effect could be the stock
selection criteria employed by the IFC-S&P. However, the average of the P5-port-

166
folios of the LAEM represents 80% of the market capitalization of the three portfo-
lios, even though P3 portfolios contain fewer stocks than P2 portfolios. Therefore, the
selection criteria used by the IFC-S&P are not the reason for the absence of a size ef-
fect. (2) For P/BV-sorted portfolios the equal return difference is statistically different
from zero only in Brazil, Chile, and Mexico. The average return of value-weighted
portfolios confirms the results. (3) The return difference of portfolios sorted by P/E is
significant in Brazil, Chile, Mexico, and Venezuela for value-weighted and equally
weighted returns. (4) A statistically significant negative relation between stock returns
and TO does not exist in any Latin American stock market. Contrary to our expecta-
tions, the return difference is significant in Chile and Venezuela, but with opposite
sign. (5) Equally and value-weighted portfolios show slightly different results.
Equally weighted portfolios usually have higher t-statistics of the return difference
^(Pi-P3) ^han value-weighted portfolios. The reason for this is that within a portfolio

there also exist small and large stocks. If small stocks have higher returns (as is ex-
pected) and are assigned the same weight, the return of the portfolios that weight their
stocks equally will have higher returns. This effect may be more extreme in small
portfolios since the size of its stocks varies more. Finally, (6) the return difference of
the portfolios sorted by P/BV or P/E is statistically significant in Brazil, Chile, and
Mexico, and these countries also happen to have the best-rated accounting systems
(see Chapter 2).

These results do not coincide with Rouwenhorst (1999). One reason for the differ-
ences could be the different sample periods used in each study. Therefore, we tested
for the analyzed anomalies in three different periods: (1) From the beginning^^^ to
November 1999 (whole period), (2) from the beginning to April 1997 (the period used
by Rouwenhorst (1999)), and (3) from May 1997 to November 1999. For each month,
stocks were sorted by 5, P/BV, P/E or TO, and grouped into three portfolios. The re-
sults obtained show that (1) for the period used by Rouwenhorst (1999) coincide with
his. (2) Returns of equally and value-weighted portfolios show slight differences. And
(3) the statistical significance of the anomalies varies with the sample period in most
of the stock markets (see Table 4.9).

'^^ Date at which the IFC-S&P begins to collect information for the corresponding stock market.

167
Another possible reason for the different results obtained by researchers could be the
frequency at which they rebalance their portfolios. As is common, stocks are sorted on
a monthly and annual basis. There are some facts that speak in favor or against one of
them. For example, due to the fast-changing environment in emerging markets, port-
folios should be revalanced frequently. On the other hand, as we showed in Chapter 3,
trading costs are higher in emerging markets and thus sorting stocks once per year
might be sufficient. For the LAEM the results show that the frequency at which stocks
are sorted influences portfolio returns (see Table 4.10).

The different number of portfolios into which stocks are sorted could be yet another
reason for the contradictory results obtained by researchers. To test whether the num-
ber of portfolios influences the significance of the anomalies, stocks were also
grouped into six portfolios. However, we did this only for Brazilian and Mexican
stocks since the EMDB does not include enough stocks from the other markets. The
return differences of the 6-portfolio approach are slightly higher than the return dif-
ferences of the 3-portfolio approach (see Table 4.11). However, despite the small
changes, the significant anomalies of the 3- and 6-portfolio approaches remain the
same.

In Table 4.12 we sunmiarize the results of Chapter 4. In sum, the variable that influ-
ences stock returns depends on the market, the period, the frequency at which stocks
are sorted, and the way stocks are weighted. The only variable that might not influ-
ence the results is the number of portfolios into which stocks are sorted.

The results obtained with the univariate portfolio approach left some questions unan-
swered: Would P be able to absorb the return variation if the fundamental variables
were to become insignificant? Or if one of the fundamental variables were to become
significant while >ff did not? Or do both of them explain the return variation? Or might
a third factor even be necessary for such an explanation? These questions were exam-
ined in Chapter 5 by means of time series and cross-sectional methodologies.

In Chapter 5 the joint roles of market returns \R^ -R^) ox market p and S, P/BV, P/E,

and TO are studied. To test the robustness of the results, the two most important
econometric methodologies of the cross-sectional analysis were used: (1) The time se-
ries regression approach developed by Black et al. (1972) and (2) the cross-sectional

168
approach developed by Fama and MacBeth (1973). For both procedures we tested
whether the one-factor model captures the variation of stock returns and whether
combinations of (/?„ - /?^) or market P, and firm S, P/BV, P/E, or TO better drive the

cross-sectional differences in stock returns in the LAEM. To my knowledge, no pre-

vious study has investigated the commonality of the various effects for the Latin
American stock markets.

The analysis in Chapter 5 was carried out at portfolio and stock level rather than at
country level. *^^ The analysis was carried out by means of the time series approach
because this methodology has several advantages. ^^^ On the other hand, the analysis at
a portfolio level has been shown to generate biases in statistical inferences (Lo and
MacKinlay (1990)). For this reason, we used the cross-sectional approach proposed
by Fama and MacBeth (1973) to test whether the market returns completely explain
the realized stock returns at a stock level. The Fama-MacBeth methodology also has
several advantages.^^^ However, according to Pettengil et al. (1995), this approach bi-
ases the relation between returns and P since it is based on expected and not on real-
ized returns. Because realized returns are used for the regressions, a segmented rela-
tion exists between realized returns and p. As a consequence, it is necessary to test for
a conditional relation between P and realized returns. Since our results were in line
with Pettengil et al. (1995), we also tested the conditional CAPM.

The results of the time series approach were presented first. For the regressions, we
used a combination of the excess market return and portfolio return differences
(P1-P3) of 5-, P/BV-, P/E-, and TO-sorted portfolios as explanatory variables. The
variables that were explained are the excess returns (portfolio return - risk-free inter-
est rate) of the S, P/BV, P/E, and TO portfolios of each country. Different variants of
Equation (5.8) were regressed.

'^^ There are several reasons for taking this approach. Emerging market returns are influenced by local
information (Harvey (1995)) since a significant number of barriers effectively segment the emerging
markets from the global capital markets (Bekaert (1995)), and the purchasing power parity varies
among the LAEM.
'^^ (1) The slopes and the R^ present direct evidence for how well the factors capture the common
variation of the stock returns; (2) it is easy to test whether the intercepts are zero; (3) the high volatility
of stock returns in a market will not lower the power of the asset pricing test; and (4) in the EMDB
there are not enough stocks to construct a two- or three-way grouping procedure.
^^Vl) With it additional risk measures beyond y^can be aggregated and (2) y^and the coefficients of the
explanatory variables are updated periodically.

169
The findings from the time series methodology reveal a strong relationship between
the realized stock returns and market excess returns or ^ and one of the additional fac-
tors, depending on the stock market. Table 5.1 shows the results of the one-factor
model, which can be reduced to three: (1) the CAPM cannot always explain the aver-
age returns of the portfolios since many intercepts are significantly different from
zero; (2) P is always highly significant, but in four stock markets it is lower in small
portfolios {FI) than in large portfolios {P3)\ and (3) in each stock market PI portfo-
lios sorted by turnover have lower p^ than P3 portfolios. Since 20% of the intercepts
of the one-factor model are different from zero, it made sense to test for combinations
of market >^ and the portfolio return differences (P1-P3) of S, P/BV, P/E, or TO. We
carried out this test after first making certain that the premium between the factors
represented by the return differences of the portfolios (P1-P3) were uncorrected.

The results of the two-factor models can be summarized as follows: (1) The explained
return variations {^) increases slightly; (2) fewer intercepts are statistically different
from zero. Intercepts are more frequently significant and negative in P3 portfolios;
this can be interpreted as an adjustment for the unexpected higher ps of P3 portfolios,
(3) Pis still highly significant; (4) one- and two-factor models produce similar/?, thus
the small improvements must come from the second factors. (5) The P/BV(P].p3) is the
factor that was most often significantly different from zero and that had the highest
average increase of R^. (6) The variables that have the greatest impact on Rp^fwary
across the LAEM: in Argentina they are S(PI.P3), P/BV(PI.P3), and P/E(pi.p3)\ in Brazil
T0(pi.p3) and P/BV(Pi.p3); in Chile S(PI.P3), P/BV(PI.P3), and T0(Pi.p3)\ in Colombia
P/BV(pj.p3) and P/E(Pi.p3)\ in Mexico P/BV(Pi.p3) and S(Pi.p3)\ in Peru P/BV(PJ.P3), S(PI.
P3), and P/E(Pi.p3)\ and in Venezuela P/BV(PI.P3) and T0(Pi.p3). (7) Across portfolios,
the PI portfolios almost always have the lowest R^ and the P5's have the highest.

The two-factor model showed that market returns and one of the mimicking factors
were significant, depending on the stock market. The next question was whether more
than one of the four fundamental variables have a significant impact at the same time
on the expected returns. The results of the three-factor models showed that (1) none of
the fundamental variables has a clear influence on the average returns. The results
vary depending on the stock market; this variation may be caused by the heterogeneity

170
of the LAEM (see Chapters 2 and 3).^^^ However, (2) P/BW is the most or the second
most important factor of the four variables in each country, and (3) TO is important
for three markets, while the size and P/E is are important only in one market each.

To check for the robustness of the time series methodology, the cross-sectional ap-
proach developed by Fama and MacBeth (1973) was also used. One-, two-, and five-
factor models were estimated. In keeping with Pettengil et al. (1995), we also calcu-
lated the conditional relation between P and realized returns. Regressions were calcu-
lated at a stock level only for Brazil and Mexico since there were not enough stocks
from the other countries included in the EMDB. The Fama-MacBeth cross-sectional
approach was carried out at stock level due to several disadvantages that the analysis
has at portfolio level. ^^^

The results of the one-factor model using the Fama-MacBeth cross-sectional method-
ology are striking. In any stock market, ^ is significant. The reason for this result is
that the market risk premia are often negative even if the expected risk premium is
positive (Elsas et al. (1999)). We therefore estimated the conditional relation between
P and realized returns (Pettengil et al. (1995)). The results of the conditional model
were consistent with those obtained in the previous sections. In all LAEM the relation
between /? and realized returns was significant. Adding factors such as S, PfBV, P/E,
or TO to the conditional one-factor model did not cause any problems. Since the addi-
tional factors always have positive values, it was not necessary to test for a condi-
tional relation between the additional factors and the realized returns.

Using the conditional cross-sectional approach, we calculated some combinations of

Equation (5.15). As with the time series approach, /? always remained significant and
the signs of 5, P/BV, P/E, and TO were not always the expected. Furthermore, the re-
sults of the conditional cross-sectional model may not coincide with the results of the
time series since the portfolio returns and the four variables are statistically related.
However, since S and P/E are economically insignificant in all countries, both ap-
proaches should coincide.

^^' The results for each country were explained in detail in section [Link].
'^° (1) All within group coefficients (intercepts) are lower (higher) than the coefficients obtained from
the full sample; (2) in most cases the coefficients (intercepts) are so small (high) that they do not pro-
vide support for the model; and (3) the I^ within regressions are also lower (Berk (1997)).

171
Overall, the results show that (1) the Latin American stock markets are heterogeneous
and riskier than developed markets. (2) The state of development in trading architec-
ture of the LAEM varies among these markets; and compared to develop markets,
their implicit trading costs are higher. (3) The return determination process in the
LAEM differs from those documented for developed markets and does not confirm
the evidence found by Fama and French (1993) for the U.S. stock markets. For the
LAEM the variable that influences stock returns depends on the market, the period,
the frequency at which stocks are sorted, and the way stocks are weighted. Further-
more, the results of the time series and cross-sectional approaches coincide: the real-
ized returns are explained by >S P/BV, and, to a lesser extent, TO. In Table 6.2 the re-
sults are summarized for each country and recommendations are also given there for
improving the efficiency of their stock markets. For each country, the main results of
this thesis are summarized in table 6.2.

172
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