Unique Risks: Political, Liquidity, and Currency

Sometimes, investing in emerging or frontier markets feels a bit like stepping into a new restaurant when you’re not quite sure how good the food will be. You might have heard good things, maybe you read a few good reviews on social media, but honestly, you don’t truly know what’s going to happen until you’ve already sat down and taken a bite. In emerging and frontier markets, the “bite” you take can be deliciously rewarding—or it can leave a bad taste in your mouth if the chef (i.e., the market) changes the recipe (i.e., the rules).

Below we explore some of the biggest “recipe changes” that can spoil the meal for equity investors in emerging and frontier markets: political volatility, liquidity constraints, and currency fluctuations. We’ll also talk about the extra country risk premium (CRP) that ties all these unique risks together when we’re calculating required returns.

Political Risk

Political risk revolves around the stability (or lack thereof) in the local government environment. Whether we’re talking about an emerging economy with rapidly evolving leadership or a small frontier country dealing with regional conflicts, any sign of policymaker instability can lead to abrupt changes in how foreign capital is treated.

• Government Stability: Perhaps you’ve seen news headlines about leaders getting impeached, constitution rewrites floating around, or entire countries flipping from one ideology to another. When leadership is shaky, regulations and business environments can shift in the blink of an eye.
• Policy Changes and Nationalization: Protectionism and nationalization can affect equities more than you might imagine. Suppose you invest in a promising telecom company only for the government to decide six months later that they want a majority stake in that industry. That can erode your equity value overnight.
• Capital Controls: Even if the local firms are robust, government-imposed capital controls—like limiting foreign currency outflows—can lock you into an illiquid investment. This risk can materialize if a country experiences a sudden capital flight or a severe recession.

Practical Tip: Before committing funds, study the country’s track record. Examine political indexes, watch for sudden arrests of business leaders, or pay attention to international bodies (IMF, World Bank) that might raise red flags. Understanding local sentiment—through news outlets, local analysts, or even social media—helps you spot issues that aren’t always obvious in English-language sources.

Liquidity Concerns

If you think about large, developed equity markets, you’ll typically see a lineup of buyers and sellers ready to trade at any moment. Emerging and frontier markets often don’t have that same depth; the number of potential counterparties is smaller, and placing big orders can push prices around more than you’d expect.

• Market Capitalization and Trade Volume: Emerging markets generally have fewer large-cap names, and frontier markets may have only a handful of regularly traded stocks. The daily volume can be shockingly low for equities that look big on paper.
• Bid-Ask Spreads and Transaction Costs: Wider spreads mean that if you’re an active trader, you may pay a premium just to get in and to exit. And, well, if you’re dealing with large orders, crossing the spread can meaningfully impact your returns.
• Lock-Up Periods for Large Positions: In many frontier markets, if you hold a massive stake, you can’t unload your shares quickly without crashing the price. This illiquidity risk is where you need to prepare for a possible 5%, 10%, even 15% immediate loss as you feed shares into a starved market.

Practical Tip: To gauge liquidity, look at the average daily trading volume relative to your intended position size. Some experienced investors use incremental trading strategies or partial block trades over time—rather than one giant market order—to reduce slippage. Also, keep an eye on local circuit breakers set by exchanges; these can freeze trading if prices move too rapidly.

Currency Risk and Exchange Controls

Currency moves can sometimes overshadow the underlying fundamentals of a stock. Imagine discovering a terrific consumer goods company in a fast-growing emerging economy, only to see any potential gains evaporate because the local currency dropped 20% against the dollar.

• Historical Volatility: Emerging-market currencies can show wild swings. Often, you need to look at the local current account situation, trade balances, foreign reserves, and central bank policies that might peg or float the currency.
• Convertibility Restrictions: Some countries restrict converting the local currency into foreign currency. Repatriating dividends or proceeds from share sales can become complicated if there’s a shortage of foreign currency reserves.
• Hedging Strategies: Large institutional investors might hedge out currency exposure using forward contracts or currency swaps. However, these products may be expensive or even unavailable in smaller markets. A partial hedge might still reduce risk.

Practical Tip: If currency risk is huge, you might decide to build an extra discount rate factor into your valuation or keep your time horizon short to minimize your exposure. Alternatively, consider holding a basket of local market currencies to diversify. Always test the practicality of hedging—sometimes, structured FX derivatives are just too pricey or too illiquid to implement in these markets.

Incorporating a Country Risk Premium

You’ve got political risk, liquidity risk, and currency risk on your plate—how do you translate these into a single measure when valuing a stock? Many practitioners expand their discount rate by tacking on a country risk premium (CRP). In other words, they’ll start with a standard global CAPM approach and then add an extra yield to account for the unique risk of that market.

A popular formula is:

• CRP Estimation Methods:
– Sovereign bond yield spreads (e.g., comparing a 10-year local bond yield with a 10-year U.S. Treasury).
– Credit Default Swap (CDS) spreads—often available for certain emerging market sovereign issuers.
– Damodaran’s approach: using equity risk premiums for developed markets plus an adjustment for country-specific default spreads and standard deviations of equity vs. bond markets.

Practical Tip: If a country’s a big commodity exporter, keep an eye on global commodity cycles. The CRP might need to be revised if, say, oil prices plummet and roil the local economy. Likewise, watch for short-term capital surges that can push down local yields, artificially deflating your CRP calculation.

Practical Applications and Advanced Notes

• Scenario Analysis: Picture a scenario where a new administration takes office and announces higher corporate taxes, or perhaps a central bank pegged the currency at an overvalued rate. Build “worst case” and “best case” versions of your discounted cash flow (DCF) or multiples-based models to see how political or monetary shifts could influence your investment.
• Stress Testing Liquidity: If you’re investing in a frontier market, jolt your trading liquidity assumptions by cutting daily volume in half or doubling the average bid-ask spread. This worst-case simulation can reveal whether a meltdown liquidity event might cause serious harm to your position.
• Double Taxation or Withholding Issues: In some jurisdictions, dividends to foreign shareholders might face heavy withholding taxes. This is an important component of your net yield analysis, not to be overlooked when you do your final valuations.

Below is a short Mermaid diagram to illustrate how major risk factors connect to the CRP in emerging and frontier markets:

    graph LR
	    A["Analyze <br/>Political Environment"] --> B["Assess <br/>Liquidity Constraints"]
	    B --> C["Evaluate <br/>Currency Factors"]
	    C --> D["Add <br/>Country Risk Premium"]

A Brief Python Example for Scenario Analysis

If you’re comfortable with Python, you could run a quick scenario test that simulates potential currency draws or expansions in the bid-ask spread. In real life, you’d obviously refine these assumptions using actual market data:

 1import random
 2
 3scenarios = 10000
 4initial_fx = 1.0   # Suppose local currency is pegged at 1:1
 5base_spread = 0.02 # 2% as an example bid-ask spread
 6
 7fx_changes = []
 8spread_changes = []
 9
10for _ in range(scenarios):
11    # Random shock to currency, range for demonstration
12    fx_shock = initial_fx + (random.uniform(-0.3, 0.3))
13    # Random shock to spread, range for demonstration
14    spread_shock = base_spread + (random.uniform(-0.01, 0.03))
15    
16    fx_changes.append(fx_shock)
17    spread_changes.append(spread_shock)
18
19avg_fx = sum(fx_changes) / scenarios
20avg_spread = sum(spread_changes) / scenarios
21
22print(f"Average simulated currency: {avg_fx:.2f}")
23print(f"Average simulated bid-ask spread: {avg_spread:.2%}")

Sure, it’s crude, but it might give you a directional sense of how a blowout in currency or local liquidity could impact your final returns.

Conclusion and Exam Tips

When venturing into emerging and frontier markets, a thorough analysis of political, liquidity, and currency risks is critical for building a realistic equity valuation. Don’t underestimate how rapidly a local government can shift policies, or how quickly a currency can tumble under global pressure or local mismanagement. Attempt to incorporate these uncertainties via explicit discount-rate adjustments (like the CRP) and scenario analyses.

• On exam day, practice item sets that revolve around a hypothetical frontier market scenario.
• Pinpoint how to separate the normal equity risk premium (ERP) from your country-specific premium.
• Watch out for potential “red flag” details in a vignette—such as references to new tariff regimes or contradictory central bank statements. These details usually hint at higher political or currency risk that must be factored into valuations.

Keeping these points in mind positions you to handle the unique set of issues that come with chasing higher returns in lesser-known markets.

Glossary

Political Risk

The risk of losses to investors due to political instability, policy changes, or expropriation.

Liquidity Premium

Additional return required by investors for holding assets with limited marketability.

Bid-Ask Spread

The difference between the price buyers are willing to pay (bid) and sellers are willing to accept (ask).

Capital Controls

Government-imposed restrictions on capital movements across borders, potentially limiting currency convertibility.

Country Risk Premium (CRP)

The extra yield demanded by investors to compensate for specific risks of investing in a foreign country, such as political and currency risks.

Convertible Currency

A currency that can be freely traded on the foreign exchange markets without restrictions.

Repatriation

Converting foreign currency into the investor’s home currency and transferring funds back to the home base.

Sovereign Yield Spread

The difference between yields on bonds issued by two different governments, often used to measure country-specific risk.

References

• Damodaran, A. (2021). “Measuring Market Risk Premiums and Country Risk Premiums.”
• International Monetary Fund (IMF): https://www.imf.org/
• World Bank’s “Ease of Doing Business” reports: https://www.worldbank.org/

Test Your Knowledge: Unique Risks in Emerging and Frontier Markets