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It has been shown that portfolio risk is reduced by introducing shares from emerging countries, whose volatility is nonetheless much greater than that of industrialized countries. The key to the mystery is that the shares of the former are only weakly correlated to those of the latter. Portfolio performance is enhanced once shares of emerging countries are brought into the mix. At least that is the case in normal times. Financial crises occasionally breed correlations that foil the best-laid mathematical schemes.
During a stock market crash in a given country, it often happens that the local currency also bites the dust. Losses for a foreign investor are even more agonizing than those suffered by a domestic investor; this is due to the correlation that appears in times of financial crisis between exchange rate risk and overall market risk. In the Mexican crisis from December 1994 to March 1995, shares dropped by about 30 percent. That said, over the same period an investor who had acquired Mexican stocks with dollars would have endured a loss of 65 percent – 35 percent more – on account of the devaluation of the Mexican peso in relation to the American dollar.
A financial crisis makes correlations appear in places where they were not expected. The ‘‘tequila’’ effect of the Mexican crisis made investors massively sell off their shares in emerging countries. So it was that the crash spread to numerous Latin American countries and also had a ripple effect across the Pacific, in Indonesia, Thailand and the Philippines.
In fact the risk of a security is composed of two distinguishable sets of risks. Systematic risk is that which cannot be eliminated through diversification strategies. It is the risk inherent to the system, the market risk. Specific risk is proper to the financial asset under consideration. It is a reflection of the risk that something happens and affects the asset (and the asset alone). This risk disappears by dint of diversification.
These two risks are independent; their correlation coefficient is 0. Total risk is the sum of the two. Three experts – William Sharpe, John Lintner and Fisher Black – have put this observation to work by building the Capital Asset Pricing Model (CAPM). The CAPM indicates the price of risk. You may recall that Louis Bachelier established that: ‘‘The mathematical expectancy of the speculator is zero.’’ As for the CAPM, it establishes a simple rule on the basis of two hypotheses: markets are in equilibrium; all investors believe in Markowitz’s theory and they choose their investment out of the same set of efficient portfolios. The rule postulates that the mathematical expectancy for an investment in a security or a portfolio must be proportional to the systematic risk. Since specific risk may be eliminated by diversification, it will not be remunerated by the market. On the other hand, the value of a portfolio has to include remuneration for the investor of an amount in proportion to the degree of systematic risk.
Market risk is attributable to the ongoing evolution of financial assets; it dictates the fluctuation of a given security. Some stocks react strongly to market movements; others do not. The degree of sensitivity to overall market fluctuation proper to a given security is known as the beta coefficient (the estimated coefficient of independent variables in a regression equation). It historically measures the systematic risk proper to a given security on the basis of comparison between the price fluctuations of the security and the fluctuations of the financial market taken as a whole. A security with a 1.0 beta presents the same risk as the market. With a beta lower than 1.0, its risk is also lower than that of the overall market; the security attenuates market fluctuations. With a beta higher than 1.0, the security tends to amplify market fluctuations. With a beta of 2.0, the instrument moves twice as much as the market. If the market rises by 10 percent, it goes up by 20 percent; when the market falls, it goes just as precipitately down. Yet for a given security, the beta does not necessarily hold steady. In other words, it takes on different values in accordance with the periods for which it is measured. On the other hand, the beta value of a market portfolio shows more stability over the course of time. It measures the responsiveness of this portfolio to market fluctuations; it quantifies its volatility.