Investors around the world are always on the lookout for
potentially profitable gigs. Aside from the
most popular investments and markets, there are always other options for
them. And one of their options are
emerging markets.
What are emerging markets?
Emerging markets, also known as developing markets, are
markets that are on their way to being advanced economies.
There isn’t really an official list where you can find which
countries are considered emerging markets.
But various banks and international organizations like the World Bank
and World Trade Organization have their own lists of such markets.
Emerging markets give you the chance to get attractive returns
as well as international diversification for investors. These markets also have their inherent risks
that you must always consider.
Here are the risks you should consider when investing in
emerging markets.
Political Risks
Political risks are those that result from a change in
government or policies in the government that have potential negative impact on
an investment. Political risks are broad
and include events like legislative changes, investment legislation, coups, terrorism,
war, trade agreements, and political elections.
The longer your investment time horizon, the more political
risks you have to withstand. This is
because it becomes more difficult to foresee political risks further out in the
future. That means more uncertainty for
you as an investor. You must then have higher risk tolerance.
You can mitigate or minimize political risks but it would
take a lot of work. You can do that by
diversification, or by investing in multiple countries. If you do it that way, a negative political
news will only affect one country in your portfolio.
Currency Risks
Also called foreign exchange risks, currency risks relate to
the risk that a certain movement in the exchange rate will negatively impact the
investor’s return. Emerging markets are
quite vulnerable to exchange rate volatility.
That means they present a larger currency risk than other more stable
currencies.
You can try to fight this risk by using hedging mechanisms. However, such things aren’t always available
on emerging markets. You can typically
accomplish hedging by using futures contracts, forwards contracts, or options.
Meanwhile, other investors do not really try to mitigate this
risk just because they think it’s too expensive, or because they believe that
the exchange rate will move in their favor.
An investing strategy that involves no hedging mechanism is also called
naked position. And it can result to
larger potential gains and losses than a covered position that uses hedging.
Liquidity Risks
This refers to the risk that an investment may be difficult
to exit and convert into cash. This is present
when the number of buyers and sellers in market is too low. This leads to wider bid-ask spreads. Within illiquid markets, investors may have
to continually lower their selling price until they come upon a willing buyer.
If you want to mitigate liquidity risks, you should be
looking for investments that have significant as well as consistent trading
volume. Investors may also want to understand
the way that foreign exchanges operate, especially the role of market makers.
Institutional Risks
This one refers to the risks that relate to standards and
regulations of capital markets within emerging markets. For instance, emerging countries’ capital
markets may have less stringent accounting standards, weak enforcement of insider
trading, and less strict regulatory oversight.
Institutional risks are difficult to mitigate, but you can
still take some steps. You must educate
yourself regarding the regulation, accounting, and insider trading environments
in the markets where you want to invest.
This can help you avoid investing in markets that you think are too
risky. It’s advised to go with large,
reputable, well-regulated auditing firms.
Conclusion
Emerging markets can give you attractive growth potential
and diversification opportunities.
Meanwhile, you should study and understand the increased risks associated
with investments into emerging markets.
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