Developing markets (also sometimes referred to as emerging markets) are markets that are working toward becoming advanced economies. While there is no formally, agreed upon list of which countries are considered developing markets, numerous international organizations, such as the World Bank and World Trade Organization, generate their own lists.
Developing markets can present attractive returns and international diversification for investors. These markets also present unique risks that investors must consider including political, currency, liquidity and institutional risk. These unique risks are in addition to risks more familiar to investors such as market, firm and credit risk.
Political risk relates to risks resulting from a change in government or government policies that can negatively impact an investment. Political risk is quite broad and captures events such as legislative changes, trade agreements, investment legislation, labor laws, coups, terrorism, war and political elections. Political risk increases as the investment time horizon becomes longer because it is harder to predict political risks further out in the future. Also, the further out in the future, the greater the probability there will be a political event that can negatively affect an investment.
Mitigating political risk can be quite challenging. Investors can attempt to mitigate political risk using diversification—by investing in multiple different countries, a negative political event in one country will only impact a portion of the investor’s total portfolio. This strategy can fail if there is significant spillover in political risk from one country to another such as from an international conflict.
Currency risk (sometimes also called foreign exchange risk) is the risk that a movement in the exchange rate will negatively impact the investor's return. Developing markets are particularly susceptible to exchange rate volatility, and therefore, they present a larger currency risk than more stable currencies.
Investors can attempt to mitigate currency risk through hedging mechanisms, but these are not always available for all developing markets. Currency hedging typically is accomplished using futures contracts, forwards contracts or options that provide an investor with a set exchange rate at a time in the future. Some investors will choose not to mitigate currency risk either because it is too expensive, or they believe the exchange rate will move in their favor. Investing with no hedging mechanism is known as a naked position and results in larger potential gains and losses than a covered position utilizing hedging.
Liquidity risk is the risk that an investment will be difficult to exit and convert to currency. This risk is present when there are few buyers and sellers in a market, resulting in larger bid-ask spreads. In illiquid markets, investors may have to continually decrease their selling price until they find a willing buyer. In extreme scenarios, there may be no buyers at any price.
This risk can be elevated in developing markets as equity and debt secondary markets are often not as liquid as developed markets. Investors looking to mitigate liquidity risk should look for investments that have significant and consistent trading volume. Investors may also want to understand how foreign exchanges operate and particularly the role of market makers.
Institutional risk is the risk related to standards and regulations of capital markets in developing countries. For example, developing countries’ capital markets may have less stringent accounting standards, less robust regulatory oversight and weak enforcement of insider trading.
While institutional risk is difficult to mitigate, there are some steps investors can take. Investors will want to educate themselves regarding the regulatory, accounting, and insider trading environment of the markets in which they plan to invest, allowing investors to completely avoid markets they deem too risky. Investors may also want to consider who the investee’s auditing firm is. It is best to go with large, well-regarded, international auditing firms.
The Bottom Line
Developing markets can provide investors with attractive growth potential and diversification opportunities. Investors will want to study and understand the increased risks associated with investments into emerging markets. Investors must decide to attempt to mitigate some of the risks or understand and accept the risks of these investments. (Read more on emerging markets, here: Emerging Markets: Analyzing Colombia's GDP.)