Author: Rutima Vaewvichit

Academic Advisor: Frank Pedersen

Diversification Benefits of Including Emerging Markets

In a Portfolio

The Case Analysis of Thailand

MSc in Finance and International Busisness

Aarhus School of Business

April/2008

Table of Content

1. Introduction 1

1.1. Problems Statement 3

1.2. Structure 4

1.3. Delimitation 5

2. Mutual Fund 6

2.1 What is Mutual Fund? 6

2.2 Types of Mutual Fund 7

2.3 Advantages of Investing in Mutual Fund 8

2.4 Disadvantages of Investing in Mutual Fund 9

2.5 Mutual Fund in The World Financial Market 10

2.6 US Mutual Fund Investment and Fund Flows to Emerging Markets 12

3. Thailand Overview 14

3.1. Thailand Economics Outlook 15

3.2. Political Outlook 19

3.3. Financial System 20

3.4. Financial Crisis and Financial Liberalization 22

3.5. Thailand SWOT Analysis 26

4. The Stock Exchange of Thailand (SET) 27

4.1. History and Roles of The Stock Exchange of Thailand 27

4.2. The Structure 28

4.3. The Stock Exchange of Thailand Overview 29

4.4. Development Direction 32

4.5. Foreign Investors 33

4.6. The Stock Exchange of Thailand SWOT Analysis 35

5. Portfolio Theory 37

5.1. Characteristics of Assets 38

5.2. Characteristics of a Portfolio 39

5.3. Portfolio Diversification 40

5.4. Evidence on International Diversification 42

5.5. International Investment and Currency Movement 44

5.6. Efficient Portfolio and Efficient Frontier 46

5.7. Optimal Portfolio Selection 48

6. Empirical Research 49

6.1. Data 49

6.2. Method 50

6.3. Empirical Results 52

7. Other Considerations 64

7.1. Market Condition 64

7.2. Portfolio Rebalancing 65

7.3. Time Diversification 65

8. Conclusion 67

9. Appendix 72

10. References 87

Table and Figure Contents

Figure 2.1 Worldwide Total Mutual Fund Net Assets, 1999-2006 10

Figure 2.2 World Mutual Fund Assets By Type of Fund, 2006Q4 10

Figure 2.3 World Mutual Fund Assets By Region, 2006Q4 10

Figure 2.4 Share of Emerging Market Mutual Funds 11

Figure 3.1 Thailand Real GDP Growth, 1993-2006 15

Table 3.1 East Asia and International Economic Growth, 2005-2008f 16

Figure 3.2 Thailand Current Account Balance, % of GDP, 1993-2006 18

Figure 3.3 Thailand External Debt and International Reserve, 2000-2006 18

Table 3.2 Total Assets of Main Finance Institution in Thailand, 2006 20

Table 3.3 Economic Indicators of Countries Affected by Financial Crisis 23

Figure 4.1 The Structure of SET 28

Figure 4.2 Outstanding Value Per GDP, 1997-2006 29

Figure 4.3 Thailand Stock Market Fluctuation, 1988-2006 30

Figure 4.4 Market Capitalization of SET, 1990-2006 30

Figure 4.5 P/E Ratio of the Stock Exchange of Thailand 1990-2006 31

Figure 4.6 Thailand Stock Market Turnover, 1990-2006 31

Table 4.1 Percentage of Stock Offering Value by Sectors, 2006 31

Figure 5.1 Efficient Frontier of Portfolio of Stocks 46

Figure 5.2 Efficient Frontier with Risk-free Asset 48

Table 6.1 World Stock Market Capitalization, 2006 53

Table 6.2 Descriptive Statistic of 1-Year Holding Period Return, 1988-2007 54

Table 6.3 Descriptive Statistic of 5-Year Holding Period Return, 1988-2007 55

Table 6.4 Correlation Coefficient of 1-Year Holding Period Return 56

Table 6.4 Correlation Coefficient of 5-Year Holding Period Return 57

Figure 6.1 Efficient Frontier of of developed market portfolio, emerging market portfolio and a portfolio combination of both developed and emerging market stocks 59

Figure 6.2 Efficient Frontier, 1-Year Holding Period 61

Figure 6.3 Efficient Frontier, 5-Year Holding Period 61

Table 6.6 Corner Portfolios, 1-year Holding Period 63

Table 6.7 Corner Portfolios, 5-year Holding Period 63

1

1 Introduction

In recent years, we have witnessed the high economic growth in developing countries that

were in a double rate than those in developed countries. During the years 2000-2005,

average gross domestic product (GDP) growth of developing countries was 5% per year

while developed countries’ average GDP growth was only around 2.3% per year. The

reasons behind this dynamic growth are due to gradual reform and globalization

phenomenon. Ongoing trade liberalization has increased levels of international

investment and trade. Many national governments have lessened trade barriers and have

open-door policy to free markets in order to stimulate cross boarder transactions.

The focus on the dynamic growth of economic in developing countries also attends to the

term of growth in emerging stock markets. Stock markets are regarded as a critical part in

realizing sustainable economic growth since they provide place where corporations can

raise and obtain capital in order to support their new projects and expansion, thereby

stock markets are an essential part to economic development. Besides the 1990s financial

crisis (in Mexico 1995, Asia 1997 and Russia 1998) in developing countries, emerging

stock markets have shown an increasing trend of high growth for the past decades1. For

example, the stock market capitalization of developing countries included in the Standard

and Poor’s IFCI index2 rose from $1.7 trillion at the end of 2002 to $4.4 trillion at the end

of 2005. In particular, the market capitalization in Asian stock market tripled during the

same period and stock prices also increased radically3. This is as a result of massive

privatization, capital liberalization, corporate restructuring, and financial innovation

programs that have fueled the development of the stock markets since 1990’s. Several

researches suggest a positive relation between liberalization and stock market

performance especially in developing countries that lucidly encourage stock market

1 The growth indicators can be inferred from number of listing companies, trade volume, variation in financial product, market capitalization and so on. There are other soft indicators that are more difficult to determined such as disclosure standard, corporate governance and etc. 2 The S&P emerging market investable indices which underlying data from International Finance Corporation in 2000. It includes only indices that open legally and practically available to foreign investors. 3 Global Development Finance 2006

2

development (Levine, 2001; Georgios, John, and Titos, 2000) and improve the country

macroeconomic performance.

As a result of significant growth and effect of globalization activities, it has stimulated

and increased cross-boarder investment. Earlier, investors might be prohibited from

owning stocks in emerging market, now they become more and more accessible. There

are also increasing availability of emerging market stocks in developed stock market such

as London, New York stock, and Japan markets. Hence, emerging markets attract an

increasing amount of capital inflows, especially portfolio flows from developed

countries. In 1997, net portfolio equity inflow to emerging market has increased from

$30.6 billion to $61.4 billion in 20054. Consequently, portfolio flows have become an

important source of external financing in emerging markets and these flow have been

channeled mainly through institutional investors, particularly mutual funds. Therefore,

Emerging stock markets became new break through for institutional investors like mutual

funds who seek for new diversification opportunities. Referring to the saying “Do not put

all of your eggs in one basket”, Diversification provides advantage of reducing unique

risk by adding more stocks to a portfolio (Haslem, 2003). Since there is low correlation

between emerging markets and mature markets as well as developed market become

more and more integrated, adding emerging market stocks to a portfolio of developed

market securities rather than holding a portfolio of only developed market stocks helps

reduce overall portfolio risk and provide greater diversification benefits. This is because

the less correlation of stocks added in the portfolio, the more of the diversification

benefits portfolio investors can achieve.

However, despite the fact that emerging stock markets are very attractive opportunities

for international investors, There still remain risks and other important factors which

affect determination of prices and the growth of stock market that investors should take

into consideration such as political stability, taxation, capital controls, investors

protection, corporate governance, investment restriction, regulations, information

reliability and availability. Moreover, many studies have indicated that different types of

4 Global Development Finance 2006

3

macroeconomic risk factors have significant influence on price and expected return of

stock markets (Azeez and Yonezawa, 2005). They are money supply, inflation, exchange

rate, and so forth. In contrast to developed market where there are more political stability,

economic advancement, investor protection, availability and accessible of information.

Thus, the condition in each emerging markets vary considerably in different countries as

well as diverse from the developed ones. They simply vary tremendously in size,

liquidity, sophistication, and regulations. Therefore, portfolio investors should not

overlook these factors that can significantly affect their portfolio performance.

1.1 Problem Statement

As emerging markets is experiencing significant growth, high performance and also the

fact that they have low correlation to developed markets, it brings the attention to this

study that aiming to analyze and discuss portfolio diversification benefit that mutual

funds managers can achieve by including emerging market stocks in their portfolio of

developed market stocks compare to a general international portfolio that include only

developed market stocks. This paper will analyze empirically why investing in emerging

market, in particularly, Thailand can be an attractive investment for Mutual funds by

using portfolio theory to suggest the diversification benefit, efficient frontier and optimal

portfolio allocation for both short and long term horizon investment according to

Markowitz’s Mean-Variance analysis. This study is of interest because it consists of

analysis of information from a specific market, The Stock Exchange of Thailand, which

there is still lack of research in this topic area. By analyzing Thailand, one of the

emerging economic countries, as a case study gives the practical view for portfolio

investors who are looking for opportunities of diversification. It will demonstrate and

point out factors that have significant effect to portfolio allocation since each countries

has unique strength and weaknesses that portfolio investor should take into consideration.

Moreover, by analyzing mutual funds, it also covers some part of pension funds and

individual investors because they basically invest in emerging markets through mutual

funds. Hence, international mutual funds have taking important role contributing

significant source of capital to emerging market.

4

1.2 Structure

This paper is structured into 6 chapters that will gradually introduce, Mutual fund as

focused investor, Thai economy, the stock exchange of Thailand and importantly, the

opportunities from including emerging market in to the portfolio that in the end the

optimal portfolio allocation to Thailand and other selected countries will be purposed.

The first chapter introduces mutual funds as focused institution investors. This explain

and gives and overview of what a mutual fund is, types of mutual funds, their activities,

advantages, and disadvantages of services offered. Moreover, this chapter discuss the

concentration of mutual fund allocation on stock and magnitude of the funds portfolio

that are allocated to emerging markets that take a very important role in the countries’

financial market development.

The Second chapter will give the overview of Thailand as an example of a developing

country investment destination. Thai economic outlook explains key macroeconomic, and

source of economic growth, which point out the economic recovery from the 1997 crisis.

The political situation in Thailand still put concerns on investors’ investment decision

due to changes in foreign investment policy and regulations. Thai financial institutions

and regulators showing the foundation of Thailand financial system are also discussed.

Then, it turns to the 1997 financial crisis and financial liberalization in order to remind

what happened and the sign that should not be overlooked. This chapter ends with

Thailand SWOT analysis.

Chapter 3 explains about Thai’s Stock Exchange. It gives understandings in the history of

Thai stock market development, and the future direction. Moreover, This section provides

investors with useful information needed when making investment decision such as

foreign investors’ investment alternatives, foreign investment regulations as well as the

Thai Stock Exchange SWOT analysis.

Chapter 4 gives more understanding about Markowitz’s Mean-Variance portfolio theory

used in empirical analysis. This chapter starts with how to measure risk-return of assets

5

and a portfolio. Then, the diversification benefits will be discussed in detail. Next, the

efficient frontier of the portfolio is defined and the method to distinguish efficient

portfolios from inefficient portfolios. Finally, the optimal portfolio selection is discussed.

Chapter 5 is contributed to the empirical analysis of optimal portfolio selection based on

the models presented in the previous chapter. The goal here is to answer whether

including emerging market stocks to a portfolio of developed market stocks rather than

investing in only developed markets stocks can improve return and reduce overall

portfolio risk. Finally, this chapter proposes optimal portfolio allocation of a combination

of develop markets stocks and emerging markets stocks including Thailand in both short-

term and long-term horizon.

The last chapter will point out other factors that mutual funds as well as other

international investors should take into consideration when using portfolio calculation.

As there is no single portfolio model that can includes every factors affecting portfolio

decision, some important factors that have significant effect to the measure of risk and

return, efficient frontier and portfolio allocation should be discussed. They are inflation,

portfolio rebalancing and time diversification.

1.3 Delimitation

This study has limited types of assets in the portfolio of Mutual funds only to common

stock and other financial assets from money market securities, derivative market

securities and other assets in capital market such as bonds and preferred stocks are

excluded from the analysis. Though the macroeconomic factors and transaction cost have

significantly effect to the stock returns, they have not been fully included in the empirical

analysis in the model of portfolio theory.

6

2 Mutual Fund

2.1 What is Mutual Fund?

A mutual fund is simply a financial institution that channel investors’ funds and saving to

invest in various investment vehicles including stocks, bonds, options and money market

securities. It pools together people who want to invest and invest for them in combination

of securities. It is more efficient and convenient for investors to invest through a mutual

fund rather than invest directly themselves because mutual funds provide portfolio

diversification, investment advisory and so forth.

A mutual fund is considered as a financial intermediary that directs a surplus of cash or

saving to productive use5. The difference between a mutual fund and other financial

intermediary such as a bank is that a mutual fund is a non-depository. Investors can invest

through mutual funds to acquire assets in financial market indirectly in return of

management fees. A mutual fund is also considered as a management investment

company that is further classified as open-end funds6. It means shares can be both sold

and redeemed continuously, unlike close-end funds.

To invest in a mutual fund, investors buy shares or a portion of a fund or an ownership in

portfolio, typically diversified and become shareholders. Each fund has predetermined

investment objectives that explain about the risk and nature of the investment, for

example high-growth fund focuses on technology company stock that give high risk and

high volatility of return. Moreover, a fund has also a fund manager who is responsible to

make investment decision and actively or passively7 managed according to the fund’s

objectives.

5 Haslem et al. 2003, 4 6 Mutual fund shares are both sold and redeemed continuously at portfolio net present value per share divided by number of shares outstanding. When mutual fund investors want to sell their share, they have to sell them back to the mutual funds as mutual funds are not traded in the secondary market. On the other hand, a close end fund shared are not redeemable and are traded like companies’ shares at prices determined by supply and demand. 7 Actively managed funds seek to earn superior return by, for example, actively buy and sell stocks, rebalancing portfolio. In contrast, passively managed funds or index funds is aiming to imitate particular benchmark indices.

7

2.2 Types of Mutual Fund

There are three basic types of mutual funds, which are stock, bond and money market

funds offered to investors8. These funds are different from each other in the perspective

of investment nature, volatility, return, and risk.

2.2.1 Stock Fund

Stock funds invest primarily in stock. When investors buy a share of stock fund, it

represents a part of ownership of the equities fund’s portfolio, thereby, they become

shareholders. Shareholders of stock fund can profit in two ways, which capital gains

when a stock price goes up, and dividend payments when a company passes its profit to

shareholders. However, investors have to face volatility of stock markets that fluctuate

from year to year and it is also difficult to predict the future performance, thus stock

funds are best used as long-term investment9. The major contribution of total mutual fund

assets is contributed to stock fund10.

2.2.2 Bond Fund

Bond funds invest primarily in Bond. It is an investment that resembles a loan. When

buying a bond, investors are lending the money to the company or government that

issued the bonds. The borrowers oblige to pay the principle and interest payment at a

maturity date. Bond funds tend to be less volatile than stock funds and produce regular

income11. Moreover the volatility of bond market and stock market differ considerably12.

For these reasons, investors can allocate part of their portfolio to bond fund to diversify

the overall risks. At the same time, bond funds give streams of income to investors.

However, there are some risks to be considered when investing in bond funds; for

example, interest rate risk13, payment risk14, and credit risk15.

8 ICI statements and publications 9 ICI statements and publications 10 Kaminsky, Lyons, and Schmukler et. al. 2001 11 ICI statements and publications. 12 Wright, D. J., Reilly, F. K. and Chan, K. C. et al. 2000 13 When interest rate goes up, bonds’ value usually decreases. 14 Payment risk is the possibility that the issuer repay the loan earlier than its maturity. This happens when interest rates are low. This forces investors to reinvest that will have a lower yield.

8

2.2.3 Money Market Fund

Money market fund invest primarily in short-term debts of corporations or governments.

It allows small investors to invest in money market by pooling money from many

investors in order to buy the securities, which otherwise require large investment. Money

market funds are considered as cash equivalent because it’s a short-term instrument that

is also yield higher return than bank saving and checking account16. There are some

concerns if investing in money market funds such as money market fund that are not

insured by the government, and inflation risk17.

2.3 Advantages of Investing in Mutual Fund

According to the growing number of mutual funds, investors have shown more and more

interest in mutual fund investment because mutual funds offer many advantages for

investors with limited knowledge, time and money. One of the most important

advantages of mutual fund is diversification. It allows investors to minimize their

portfolio risk at a given level of return18 by mixing investment type within a portfolio,

such as a variety of securities, markets, industry sectors and maturities. It helps reduce

the impact of any one security in a portfolio. Another important service advantage is that

mutual fund offer a professional portfolio management. Each fund has a portfolio

manager who makes investment decisions and make sure that it meets the fund’s

objectives by using different financial tools and analysis including portfolio allocation,

fundamental analysis, active and passive portfolio management styles and so forth. When

buying a mutual fund, investors are offered with a wide variety of investment objectives19

that can meet a variety of investors’ need and risk preferences. For example, a portfolio

with high growth objective might appeal to aggressive investors with high-risk

preferences and a portfolio with long-term capital growth that invest in only high-quality

company might appeal to the opposite. Another advantage of a mutual fund is that the

15 Credit risk is the possibility that bonds issuer unable to payback the loan, the bond is said to be default. 16 The MorningStar 17 ICI statements and publications 18 The mechanic and research of portfolio diversification will be explained in theory section. 19 Please see Appendix 1 for example of classification of mutual fund objectives.

9

buying and selling size for fund is large compare to the buying and selling of individual

investors, thereby it create economy of scale and reducing transaction cost. Moreover,

by buying a mutual fund, it allows investors to have a divisibility. They don’t have to wait

until they have a large sum of money to diversify portfolio of stocks, in contrast mutual

fund allows them to buy a fraction of a portfolio. Mutual fund is also considered a

liquidity investment because investors can buy or redeem shares any business days. It

gives the ability to access to investors money easily. Finally, there are other shareholder

service advantages that contributed to the growth of the industry including financial

advice, fund accessibility, and transaction handling among others.

2.4 Disadvantages of Investing in Mutual Fund

However, mutual funds provide some general disadvantages. For example, according to

the fact that mutual funds are not allowed to invest directly in tangible assets20 for

instances, fine art, real estate, and commodity products. This investment type limitation

has obstructed investors from opportunities of mixing various assets types that has

different market correlation, which will help reduce the total portfolio risk. In addition,

though mutual funds provide investors with professional management service, it always

comes at a cost. These fund expenses include fund management fee, soft dollar fee21,

commission cost. Some operating fees are charged as annual percentage fee regardless of

the fund performance. Thus, when comparing fund performance, net return after expenses

should be used. Although mutual diversification can reduce the overall of portfolio risk, it

can also be disadvantage due to dilution of return. For example, when a security price is

double, mutual fund will not be double in value because a drop in other stock might

cancel it out. Moreover, despite of the advantage that mutual fund offer professional

portfolio management, investors have lack of control over the investment decision

regarding when to buy and sell and thereby they cannot control their tax consequences.

20 Kaminsky, Lyons, and Schmukler et. al. 2001 21 Soft dollar fees are hidden fees that mutual fund pass on to investors for example, fees that mutual funds pay their brokerage firms that include other cost than just trading fees.

10

2.5 Mutual fund in the world financial market

Investment Company Institution

reported the continuing growth of

mutual fund in the world market. The

total asset of mutual fund in the year

1999 were $11.76 trillion and by

2006 they has escalated by $21.76

trillion which nearly double within 7

years22(figure 2.1) with the annual

growth rate close to 10%. At the end

of the fourth quarter of 2006, 48 % of

the total worldwide mutual fund

assets represent equity or stock fund,

18% for both asset share of Bond and

money market funds. Balanced/Mixed

fund assets represent 10% of the total

(figure 2.2). Particularly, 52% of the

total mutual fund assets accounted for

the Americas. In contrast, Europe

accounts for 36% and 12% for Asia

(figure 2.3).

There are several forces that explain

the expansion of mutual fund market.

Fundamentally, economic condition,

corporate profit growth, low inflation,

22 The Investment Company Institute compiles worldwide statistics on behalf of the International Investment Funds Association, an organization of national mutual fund associations. The collection for the first quarter of 2007 contains statistics from 42 countries. (Appendix 2)

Figure 2.1 Worldwide Total Mutual Fund Net Assets, 1999-2006

Source: ICI Fact Book 2007

Source: ICI Fact Book 2007

Figure 2.2 World Mutual Fund Assets By Type of Fund, 2006:Q4

Source: ICI Fact Book 2007

Figure 2.3 World Mutual Fund Assets By Region, 2006:Q4

11

exceptional stock returns and relatively low interest rate favor all securities investment

including mutual fund23. Moreover, regarding to the advantages of mutual fund, it is an

alternative investment that provides a single package of portfolio diversification, and

professional portfolio management, among others. Thus, investors tend to invest more

and more in mutual fund.

Another contribution to the growth

of mutual fund industry is also the

rapid growth of the local mutual

funds in emerging market that offer

both individual and institution

investors to access to emerging

market easier. According to

Investment Company Institution,

Mutual fund industry in emerging

markets has grown rapidly since

199024. At the end of 2003, the industry has grown by 19 times of its size in 199025.

Despite of the worldwide surge of mutual fund industry, mutual fund in emerging market

represent less than 5.7 percent of net global total assets. However, the trend of the

emerging markets show strong stock market performances according to the experienced

economic growth, following the economic reform, privatization and lowered trade

barrier. Thus, with this rapid growth rate, emerging market mutual funds will have more

significant part in the world mutual fund industry.

2.5 US Mutual Fund Investment and Fund Flows to Emerging Markets

The US has by far the largest mutual fund industry in the world, represents 48% of the

world total mutual fund net assets in 2006 (Appendix 2). The US mutual fund net assets

recorded $10.4 trillion of assets under management in 2006, compared to $21.8 trillion in 23 Investment Company Institution 24 Ong and Sy et. al. 2004, 4 25 Ong and Sy et. al. 2004, 4

Figure 2.4 Share of Emerging Market Mutual Funds

Source: ICI Fact Book 2007

12

the world mutual fund assets, which has increased 17% from previous year. Based on the

US history, mutual fund is found to be an effective investment vehicle that provide

market rates of return for both individual and institution investors. The growth in mutual

fund demand is a result of strong fund performance. Dividend and capital gains are

reinvested; consequently, it generated new funds26. For these reasons, there are growing

interests of U.S. companies’ pension plan27, and household28 that increase their assets

allocation to mutual fund investment. Thus, this increase in demand of mutual fund led to

a creation of larger number of new mutual fund and mutual fund assets29. Stock mutual

funds account for 57% of US mutual fund assets by year end 2006 and it has ranged

around 50% to 60% since 1997. Since 2004, U.S investors tend to reduce their

investment in domestic stock funds and increased their purchase in foreign or

international funds. This reflects the strong performance of foreign stock market,

especially in the emerging economy that recorded total return close to 77%, in contrast to

range of 12% to 21% in the US market and 45% in the world market (exclude US stock

market)30.

In recent years, mutual funds allocation based from developed countries to emerging

market has grown considerably, as there are increasing in global investment

opportunities, countries continue to liberalize, and reduce trade barrier. Thus, the funds

inflow from mutual fund portfolio allocation has become an important source of external

financing for those developing countries. As U.S is the largest mutual fund market in the

world, its mutual funds flow contributed to emerging market is also in considerable size.

According to Ong and Sy’s document, in 1996, U.S mutual funds alone allocated their

assets to emerging stock markets from $58 billion USD, in comparison to $63.2 billion

26 ICI reported that in 1990 to 2000, nearly half of the growth was contributed to the reinvestment. 27 At year end 2006, U.S. mutual fund accounted $4.1 trillions or 25% of $16.4 trillions of U.S. retirement market. The remaining assets were managed by banks, brokerage firms, insurance companies, and pension funds (Appendix 3). 28 US household have reduced their reliance on bank deposit and direct holding of stocks and bonds, but increased their reliance on mutual fund. ICI stated that in 2006 U.S. mutual funds managed 23% of household assets, which has increased from 8% in 1990 (Appendix 4). 29 In 2006, the numbers of worldwide mutual funds recorded 61,506, increased from 2005 for 8% (Appendix 5) 30 ICI Factbook 2007, 23

13

USD in 200331. However, regarding bond fund, the US allocates its mutual fund asset at

a less significant level to emerging market bond around 25.7 billion US dollars in 1996

and remain at the same level at 25.5 billions US dollars in 200332. Thus, it shows that

these portfolios are more concentrated in equities rather than bond (Appendix 6).

Considering the type of funds, both individual and institution investors allocate part of

their portfolio to emerging market through international equity fund, regional equity

fund, dedicated emerging market fund, global equity fund accordingly. U.S. International

equity fund and regional equity fund allocate around 12% of the funds to emerging

market, while global equity fund allocates around 6%. Even though these equity funds

allocated to emerging market are considered a small fraction of total US mutual fund

investment, it is considered an important presence in the economies due to the small size

of their capital markets33(Appendix 7).

31 Ong and Sy et. al. 2004, 21 32 Ong and Sy et. al. 2004, 21 33 Kaminsky, Lyons, and Schmukler et. al. 2001, 321

14

3 Thailand Overview

Once before 1997, Thai economy had performed exceptionally well. The growth rate of

Thai export from 1990 to 1995 is around 19%annually. Economic growth was averaging

at 7.6 percent for two decades from 1977 to 199634. In additional to that, Thai financial

market also reacted to the economic growth. The benchmark SET index rose from 613

points at the end of 1990 and peaked at 1410 points at the end of 1996. Following with

the financial liberalization in the late 1980s, Thailand is one of the fastest growing

economies in the world. It was classified by the World Bank (1993) as one of the eight

High Performance Asian Economy (HPAEs)35. However, on 2nd July 1997, due to the

capital outflow and insufficient international reserve of the country, it is unavoidable that

Thailand had to change its currency system from fixed to floating currency exchange rate,

This day is designate as the start of Thailand economic and financial crisis and spreading

across Asia and caused Asian economic miracle to end.

Today, Thailand has recovered from the 1997 crisis and back on its long-term

perspective. Annual GDP growth rate from 2002 to 2007 is around 4.5 % compare to

those in developed economy with 2-3 %. It has been proven that many of emerging

economy including Thailand can sustain growth. Hence, Thailand become on of the

emerging market economy that attracts investment flows from both foreign individual

and institution investors especially those in developed countries. However, some main

challenges remain in emerging market economies that investors have to encounter

macroeconomic stability, political stability, and different investment restrictions.

Therefore, this chapter is dedicated to overview of Thailand’s economic, political,

monetary, and financial system overview that will be as of interest of foreign investors,

especially mutual funds. It shows the present condition how the country has recovered

from the 1997 crisis. Moreover, the issues of the financial crisis and financial

liberalization explain what was wrong in the past and how the country was developed

34 Siamwalla et. al. 2000, 2 35 The eighth High Performance Asian Economies (HPAEs) includes an already mature market like Japan, the Four Asian Tiger like Hong Kong, Singapore, South Korea and Taiwan, and Newly Industrializing Economies like Thailand, Indonesia, and Malaysia.

15

until the present. Finally, Thailand SWOT analysis was presented as a conclusion for this

part.

3.1 Thailand Economic Outlook36

3.1.1 Economic Activities

Today, Thailand is said to be recovered from the economic and financial crisis ten years

ago and it now regain its position as one of the most attractive investment destination

among the emerging economy countries37. From figure 3.1, in the period of the financial

crisis, Thailand’s real GDP growth dropped dramatically to the lowest point at negative

8.5% in 1998. For the past 5 years from 2002-2006, the real GDP growth is around 5%

average, that is more sustained and inline with its economic condition than in the pre-

crisis period. In 2007, real GDP was expected to grow by 4.3 percent, at a slower pace of

5 percent in 2006. Although this growth is considered unfavorable and not outstanding

compare to other emerging economy in Asia, Thailand is still growing in a faster pace

than those from developed countries (See Table 3.1).

Figure 3.1 Thailand Real GDP Growth, 1993-2006

Source: CIA the world FactBook 1993-2007

36 Appendix 8: Thailand Key Statistic 37 According to the World Bank definition, Emerging economies are countries with low or middle levels of GNP per capita as well as five high-income developing economies -Hong Kong (China), Israel, Kuwait, Singapore, and the United Arab Emirates, despite their high per capita income because of their economic structure or the official opinion of their governments. More than 80 percent of the world's population lives in the more than 100 developing countries. (Appendix 9: The World Bank Economy Classification)

16

Table 3.1 East Asia and International Economic Growths

Source: World Bank east Asia Region (October 2007), Bank of Thailand

One of the reasons for the economic slow down in recent years is primarily due to the

slow down in export since export is a robust source of Thailand economic growth that

accounts for around 60 percent of GDP. In 2007, export of goods grew at a slower rate of

6 percent compare to 9 percent in 2006 according to the slow down in world economy.

Export of services has improved since 2005, the year affected by tsunami. Another reason

contributed to the slow down in export is the Baht appreciation around 14%39 of the US

dollar since 2005 caused Thailand to loose competitiveness in the world market. In 2006,

Baht appreciated by 8% was due to the current account recovery and continuous capital

inflows. This trend can be expected in the future, as the interest in Thai equity market

will keep the Baht strong. Lastly, the downtrend is also due to the political turmoil that

affect directly to investor and consumer sentiment. Thereby, Thailand has to face a period

of low domestic demand. However, it is expected that the economy will accelerate again

in 2008 after the new election as investors and consumers can see the clearer future and

thereby can gain back their confidences.

38 A forecast of the year 2008 39 IMF Public Information Notice (2007)

2005 2006 2007 2008f38 Emerging East Asia Develop. E. Asia Indonesia Malaysia Philippines Thailand High Income countries Developing countries China Japan United States World

7.7 9.2 5.7 5.0 4.9 4.5 2.6 6.8 10.4 1.9 3.1 3.4

8.3 9.8 5.5 5.9 5.7 5.0 2.9 7.5 11.1 2.2 2.9 3.9

8.4 10.2 6.3 5.7 6.7 4.3 2.4 7.4 11.3 2.0 1.9 3.5

8.2 9.7 6.4 5.9 6.2 4.6 2.3 7.1 10.8 1.8 2.0 3.4

17

3.1.2 Government Policies

According to Thailand monetary policy, after the pegged exchange rate regime had

ended in 1997, monetary targeting had been adopted from 1997 to 2000. Bank of

Thailand targeted the money supply to obtain sustainable growth and price stability. After

2000 till present, the policy has changed to inflation targeting regime because the

relationship between money supply and growth become less stable in the time of major

crisis and in the period of rapidly changing of financial sector40.

To response to the economic slow down, The Minister of Finance and The Bank of

Thailand has relax the exchange control regulation41 to allow greater flexibility for Thai

businesses in their investment abroad and foreign exchange. This will facilitate the

outflows in order to balance with the pouring inflows that create the Baht appreciation.

Moreover, the Bank of Thailand has reduced interest rate in 2007 in order to help

accelerate the private consumption and investment. Regarding the fiscal policy in 2007,

the government decided to maintain the deficit account by increasing government

expenditures. There are still many aspects that require significant improvement such as

education, health care and housing. Thus, effective government spending will strengthen

the country infrastructure.

3.1.3 Financial Stability

Regarding internal stability, The Bank of Thailand use inflation targeting as a tools to

manage the money circulation within the economy. High oil and food prices can

significantly affect inflation rate.

Regarding external stability, Thailand has run a moderate trade surplus (Table3.2) since

the year of the crisis. Except for the year 2005 following the global oil price surge, the

import price increased and it turned the account balance into deficit.

40 Bank of Thailand 41Bank of Thailand

18

Figure 3.2 Thailand Current Account Balance, % of GDP, 1993-2006

Source: Bank of Thailand

Moreover, International reserve has increased from 26.2 billion USD in 1997 to 65.1

billion USD in 2006, while the external debt declined from 109.4 billion USD in 1997 to

58.6 billion USD in 2006, which considered 28.3 percent of GDP. This is due to the early

repayment of external debt to IMF in 2003 that brought down the public external debt

significantly. This reflects the strong macroeconomic and balance of payment

performance as a result of sound economic policy.

Figure 3.3 Thailand External Debt and International Reserve, 2000-2006

Source: Bank of Thailand

19

3.2 Political Outlook

Thailand is a constitutional monarchy with the king as the head of the state, where

democracy system has not yet been fully developed. The country has struggled through a

series of military government and a number of brief periods of democracy. According to

Thai’s politic history, Thailand was transformed from an absolute to a constitution

monarchy under the King Rama VII period in 1932. Afterward, changes of governments

were by means of mostly bloodless coups, except for in October 1973 when violence

broke out in the demonstration against the military regime. In 1988 that Thailand has the

first democratically elected prime minister in decades. Unfortunately, three years later, a

bloodless coup end his terms. Following were another 4 elections in 1992, 1995, 1996,

and 199742, which all were early dissolve of governments.

Until 2001, Taksin Shinawatra, a telecommunication multimillionaire, a leader of Thai

Rak Thai(TRT) party, was elected a prime minister and was the first one to stay his full

term in the Thai’s political history. With the rapid recovery in Thai economy and early

debt repayment to IMF, Taksin was reelected for the second term in 2005 with the large

majority votes. However, in his second term, there were thousands of people

demonstrating against allegation of corruption in favor to his private telecommunication

business. Consequently, in 2006 Taksin called for a snap election in the period of 2

months after he dissolved the parliament. This caused the opponent party to boycott the

polls and the election was declared invalid. Later on, another military coup seized control

of the country and appointed interim prime minister.

The recent coup caused Thailand’s image to suffer and investors’ and consumers’

confidence weakened. The immediate effect was that the Stock Exchange of Thailand

(SET) plunged 15 percent by the end of the day after the military coup imposed new

economic policy that seem to be more restricted and more preserved. Consequently, some

investors cut down their investment plan due to a decrease in consumption. Some will

delay their financial investment after the election with the hope that the election will end 42 In 1997, Thailand faced severe economic crisis. The present government at that period dissolved the parliament due to the question of his incompetence dealing with the crisis.

20

the political turmoil. This political instability can frighten potential investors. Investors

and consumers lost their confidences due to the fact that they do not know what will

happen ahead, as a result, the country may face capital outflows and slow down in

consumption and investment including from both domestic and foreign investors, which

thereby lead to the country economic slow down. Overall, Thailand’s political condition

seems vulnerable. Although, the new democratic election was held in December 2007,

there are still likelihoods of weak government. The Military still seem remains influences

over Thai politic and also the powerful military can remove the government by mean of

coup. This has raised questions about Thailand’s democracy over the long term.

3.3 Financial System

3.3.1 Financial Institutions

Thailand financial system consists of commercial banks, credit companies, credit foncier

companies, Government Saving Bank, private and government insurance companies, The

stock exchange, The Export-Import Bank, Small and Medium Enterprise Development

bank, asset management companies, mutual fund management companies, Provident fund

Pawnshop and other financial institutions among others. According to Table 2, it shows

that commercial banks dominate most of the financial assets. Banking sectors continue to

play an important role in Thai economy with estimated financial assets at 200% of GDP. Table 3. 2 Total Assets of the Main Finance Institutions in Thailand, 2006

Finance Institutions Assets (Millions of Bath)

Commercial Banks (exclude branch offices abroad) Government Saving Bank Government Housing Bank Bank of Agriculture and Agricultural Cooperatives Finance Companies and the Stock Exchange of Thailand Export-Import Bank Small and Medium Enterprise Development bank Credit Foncier Companies

8,856,579

729,207 633,758 608,792 101,785

75,153 59,934

2,285

Source: Bank of Thailand

21

3.3.2 Financial System Regulators

The main institutions that responsible for policies and supervision of the country financial

system are The Bank of Thailand and The Ministry of Finance.

Bank of Thailand or (BOT) was established in 1939 under the name The Thai National

Bureau as a department attached to the Ministry of Finance. Its primary goal is to

maintain monetary and financial stability that is essential for the growth of the economy

in the long run. The bank of Thailand can influence the economy through the use of

monetary policy to control inflation and set interest rate that thereby affect the exchange

rate. The roles and responsibility of the Bank of Thailand43 are to (1) promote monetary

stability and formulate monetary policies in order to strengthen the economic and finance

conditions in Thailand; (2) promote financial institutions’ stability and supervise financial

institutions44 and make sure that they meet the international standard and help stimulate

the economy; (3) provide banking facilities including depository, lending and foreign

exchange transaction as well as recommend economic policies to the government; (4)

provide banking facilities for financial institutions by maintaining reserve for financial

institution and acting as a lender of a last resort; (5) manage the country’s international

reserve through maintaining currency reserve to ensure stability and confidence in the

currency; (6) print and issue bank note to be in line with demand by the economic

system.

The Ministry of Finance is the official existence of the government agency to

administer the national finance and supervise matters concerning public finance, taxation,

treasury, Government property, operations of Government monopolies, revenue-

generating enterprises, as well as other organizations to which the Government has

contractual obligations. It is also vested with the power to provide loan guarantees for

the Government agencies, financial institutions, and state enterprises.

43 Bank of Thailand 44 Financial institution includes commercial banks, financial and credit foncier companies, International Banking Facilities (BIBF), asset management companies, non-bank credit card businesses and credit bureau.

22

3.4 Financial crisis and financial liberalization

3.4.1 The 1997 Crisis

The goal of this part is to identify the factors contributing to Thailand economic crisis in

1997 by determining the misleading signals that led to economic overconfidence.

According to Krugman, the source of economic growth can be achieved through increase

in inputs of labor and capital rather than productive gain, and therefore, it is inevitable

that the economy had to confront the diminish of returns. When the Thai government

introduce the country to the industrialize regime since 1960s through the mobilization of

resource by moving from agricultural to industrial base. Adding to that, Board of tariff

exemption. Consequently, export grew rapidly at the rate 28 percent per annum between

1988 to 199545. The GDP growth rose continually until there is no further scope of

mobilization, thereby Thailand inevitably faced the slowdown in the growth rate.

Thailand economy already slowed down in 1996 and recorded negative growth in 1997.

Another warning signal that went unnoticed under persuasive economic boom is

Thailand’s external account in 1996, which there are some similarities with the external

account of Mexico in 1994. Table 3.3 reveals the similarities of external accounts

between Thailand, Malaysia, and Indonesia in 1996 compare to Mexico in 1994. One

obvious sign is the current account deficit per GDP and large foreign debt that is even

larger than the Mexico’s debt level in 1994. This massive account deficit, high foreign

debt and excessive monetary growth encouraged speculators to attack the currencies46.

Although Thailand recorded much higher foreign reserve than Mexico, significant part of

the reserve comprised of short-term foreign capital in relative to long-term capital. Thus,

it put the country in vulnerable position that the flight of short-term capital was one of the

reasons of dramatically decline in reserve during 1997 and 199847.

45 Jackson, K. D. et al. 1999 46 Ryan, L. et. al. 2000, 808 47 Warr, P. et. al. 1999, 640

23

Table 3.3 Economic Indicators of Countries Affected by Financial Crisis

1996 1994

Economic Indicators Indonesia Malaysia Philippine South Korea Thailand Mexico

Foreign reserves as percentage of short-term debt 73 186 84 147 109 20

Foreign reserves import cover, months 4.4 3.7 3.4 3.2 6.6 1.0

Foreign debt as percentage of GDP 47 39 54 17 46 35

Current account deficit as percentage of GDP 3.7 9.7 1.7 2.3 7.7 7.8

Domestic savings as percentage of GDP 29 32 19 32 36 15

Budget balance as percentage of GDP -2.4 0.7 0.9 1.0 2.9 -0.7

FDI plus current account deficit as percentage of GDP -1.8 -3.8 0.0 -2.1 -7.5 -5.6

Under/overvaluation of currency -26 -36 -30 19 -20 5 Money supply percentage increase of year earlier 21 16 24 15 18 23

Source: Ryan, L. et al. 2000,

As a result of false impression of the economic growth and the absent of appropriate

reactions to the warning signals, Thai regulators relaxed the banking and financial

disciplines48. During the early 1990s Thailand liberalized the capital control to facilitate

both the entry and exit of foreign funds, while Baht was still pegged to the US dollars.

More foreign investment poured into booming economy of Thailand easily, especially

temporary or short-term foreign investment. As Bank of Thailand maintain high interest

rate in order to keep inflation low, banks and financial institutions were encouraged to

borrow foreign currency because they can borrow foreign loans cheaper than domestic

loans. Consequently, it led to increase in capital inflows. Especially those inflows were

mostly short-term and unhedged to currency fluctuation. There were also mismatched

between the short-term borrowed funds and a long-term investment in prestige real estate

and property development where excess capacity already existed. As a result of investor

overconfidence, the quality of the investment decline, and most was proven to be

financial non-performing. It put banks and financial institution in vulnerable position.

48 Ryan, L. et al. 2000, 809

24

By 1996, Thailand lost competitiveness in the international trade, Thai export growth

dropped close to zero. One of the reasons is because Thai real wages had increased

gradually by 70 percent from 1982 to 1994 and it put Thailand in an inferior

competitiveness compare to other developing countries in low wage labor intensive.

Another reason was to keep Baht pegged to US dollar while the dollars rose in the mid

1990s, thereby Thai export become less competitive contributing to export difficulties49.

As export declined, Thailand faced more current account deficit. This provoked the

capital outflow and speculation against Baht due to the expectation of Baht devaluation50.

Due to the combination of week macroeconomic, false impression of the boom and the

devaluation of Baht that caused investors’ confidence to collapse, giving huge capital

repatriation. Foreign investors began to pool back their investment from the country and

baht devaluated. Thai government tried to protect the fixed currency until the foreign

reserve was drained up which led to the decision to change the currency exchange system

from fixed rate to floating rate in July 1997, given Thailand huge debt exposure. Thus,

Thailand was compelled to accept a bail out package from IMF that took away control

over its own economic and financial policy. Thailand had to meet restrictive requirements

of fiscal and monetary major reform and restructuring. Consequently, 56 finance

companies were shut down and 4 commercial banks were taken over by the government

between the year 1997 to 1998. Investors lost their confidences on Thai’s economy,

financial market and system as well as political stability. Hence, there were calls for

restructuring and reforming in the Bank of Thailand to tighten the policies and

transparency. However, export grew by 10 percent and Thailand gained competitiveness

of export in 1997 following the devaluation of Baht.

3.4.2 Financial Market Deregulation and Liberalization

The period of late 1980s and early 1990s had been a critical reform and economic

restructuring including financial liberalization and economic integration. It was hoped

49 Asian Contagion, The Causes and Consequences of a Financial Crisis. (1999) 50 Warr, P. et al. 1999, 642

25

that Thailand would be the new regional financial center like Hong Kong. However,

liberalization is a double-edged sword, if it is poorly managed.

During the period 1980-1987, Thailand implemented a macroeconomic stabilization

program through devaluation of nominal exchange rate by 15% and tightened monetary

policy. According to the liberalization of the capital account, in 1985 both current and

capital account were liberalized and by end of 1994 there was no restriction on foreign

exchange on current account, which thereby facilitate the foreign investment. In 1991,

foreign direct investment were liberalized by giving 100 percent ownership to for foreign

company that export all their output. Regarding foreign exchange system, Thai

government established Bangkok International Banking Facility in 1993 as an offshore

financial market that benefited from tax and regulatory terms. Its main activity is to lend

out foreign currency. Furthermore, repatriation of investment fund, interest and loan

repayment by foreign investors was fully liberalized. Ceiling interest rate for both deposit

and lending interest rate were remove over 1989 to 1992 according to the increase in

foreign rate and the open capital market regime in 1980. As a result of the reform cause,

the money supply increased.

Following these liberalizations, Thailand had to deal with large capital inflows especially

short-term investment that poured into the country. The liberalizations, accompanied with

weak financial sectors condition and lack of strong regulatory framework, had

contributed to the fragility of the macro condition and risk-taking behavior by the

financial institutions. The evidences from the financial crisis in 1997 reveal that financial

sector and capital account liberalization program need to be carefully managed.

26

3.5 Thailand SWOT Analysis

Strengths

• Thailand has recovered from the 1997 financial crisis and have a more sustain

and healthier financial condition. Sound fiscal and monetary policies have

maintained inflation and raise foreign reserve.

• The banking sectors become stronger and more aware since the financial crisis

due to the restructuring and recapitalization efforts, which lead to a better

performance of bank and financial institutions, lower non-performing loan,

better risk management and so forth.

Weaknesses

• As 60% of the GDP of Thai economy depends on export, Thailand is vulnerable

to external demand and appreciation of exchange rate

• Political instability raises a question of the long term perspective of the country

that affect investors and consumer sentiment and have negative effect to the

financial market.

Threats

• Global oil price surge affect the net import of the country and put the current

account in deficit. This can also slow down business

• Bath appreciation has a direct negative effect that hurt Thailand’s export.

Opportunities

• Thailand is trying to differentiate itself to be a knowledge based rather than low

cost labor intensive.

• The low valuation of dollar and strong region or emerging market economy

performance has attracted global investors to direct investment and financial

assets.

27

4 The stock exchanges of Thailand (SET)

The year 2003 is the year of significant growth for Thai stock market after the 1997

crisis. Considering 117% stock return, it recorded among the top in the global stock

markets. This chapter explain where SET stand in the world capital market and where it

is heading. It provides investors a better understanding of the opportunities and risk

access that the stock exchange of Thailand imposes.

4.1 History and Roles of the Stock Exchange of Thailand

The introduction of Thai capital market can be traced back to the second National and

Social development Plan (1967-1971) that purposed the establishment of orderly security

market in order to mobilize capital to support economic growth and stability. As Thai

economy developed and expanded, available financial institutions have limitation in

providing enough capital for business and most are short-term. Thus, the stock exchange

took essential role in providing capital for business. The Stock Exchanges of Thailand or

SET was established in 1974 under the name “Security Exchange of Thailand” under the

1974 Security Exchange Act of Thailand and started official trading in April 1975.

However, Thai stock market had begun far back in 1962, it was operated as a limited

company under the name “Bangkok Stock Exchange Co., Ltd” and ceased its operations

when The Securities Exchange of Thailand was established as a sole stock exchange in

Thailand. In January 1991, The Securities Exchange of Thailand changed its name to

“The Stock Exchange of Thailand (SET)”.

The main roles of SET is to serve as a center of securities trading of listed companies and

facilitate the trading, undertake business related to Securities Exchange such as a clearing

house, securities depository center, securities registration among others. The operations

of SET includes securities listing, supervision of listed companies, information disclosure

and corporate governance, trading, market surveillance and member supervision,

information dissemination and investor education.

28

4.2 The Structure

In 1992, The Security Exchange Commission was founded as supervisory agency and

serve as a regulator for Thai capital market including both primary and secondary

markets, whereas the Bank of Thailand is responsible for the money market and financial

sector. SET is operated as a private company under regulation of SEC and Ministry of

Finance. SEC oversees the primary

market by granting approval for

initial public offering or additional

securities issuing to companies that

comply with its requirement. After

the issuance, SET has a

responsibility to grant approval for

those securities to be traded in

secondary market. Only member

companies of the SET are allowed

to buy or sell securities on the SET.

SET also provides additional services to the market participants through its subsidiaries

in the SET Group. Thailand Securities Depositories Co., Ltd. (TSD) began its

operation in 1995 as a function to promote and facilitate after trade services including

securities depository, clearing and settlement, securities registration, fund registration and

back office services to manage post-trading data for financial companies. Thai Trust

Fund Management Co., Ltd. was introduced in 1996 as a passive open-ended mutual

fund investing in securities of listed companies on behalf of foreign investors. It allows

the promotion of foreign investment in Thailand. In 1998, The Market for Alternative

Investment (MAI)51 was established to attract small and medium sized enterprises that

have high potential for growth and want to raise long-term fund from the capital market.

In 2000, SET founded Settrade.Com Ltd. to facilitate stock trading and information

distribution via Internet and Thai NVDR Co., Ltd. as a gateway for foreign investors to 51 Listing requirement in MAI is considered more flexible than listing in SET. For instances, in terms of start up capital, companies need only 0.96 to 4.8 million USD to be eligible of listing, in contrast to listing on the SET that require capital at the minimum of 4.8 million USD.

Source: The Stock Exchange of Thailand

Figure 4.1 The Structure of SET

29

invest in Thailand through non-voting depository receipt. Bond Electronic Exchange

(BEX) was founded in 2003 to facilitate electronic bond and increase trading channel for

investors. The latest subsidiary launched was Thai Future Exchange Pcl. (TFEX) in

2004 as a derivatives exchange offering trading and hedging of derivatives products,

thereby used by investors as tools for risk management. In addition, SET promote

understanding for individual investors and students about Thailand capital market,

investment principles among others through Family Know-How Co., Ltd. The

expansion of SET’s selection of products and services through its subsidiaries allow SET

to provide full range of products and services. At the same time, it allows Thailand

capital market to be more integrated and provide more alternative investments.

Consequently, SET increase its roles as an important source of fund for private sectors

and the element of Thailand economic growth.

4.3 The Stock market of Thailand Overview

Thailand Stock market is becoming increasingly significant component of Thai Capital

market. Thai business rely more and more on financing from the capital market and the

trend for financing from bank sectors is decreasing. In 2003, Equity financing was for the

first time grew more than two folds

and recorded 81% of GDP, which

was more than bank loan accounted

for 74% of GDP (Figure 4.2). The

use of debt instrument remains the

lowest. Hence, Thailand relies more

on equity financing then debt

instrument, in contrast to others in

develop economies52.

The major boom in the Thai stock market history started in 1990 following the financial

liberalization and reform, the economic growth and the inflow of foreign capital. The

52Vichyanond et al. 2002

Figure 4.2 Outstanding Value Per GDP, 1997-2006

Source: the Security Exchange Commission of Thailand

30

boom reached the highest point since the stock market has been operated at 1683 points

in 1993. Both foreign and Thai investors had pulled up the price far away from its

fundamental. Then, the SET index dropped to 372 points in the 1997 crisis following the

devaluation of Baht. At the end of 2006 the index closed at 679 points, which has not yet

reached the pre-crisis level. Graph2 show how the SET index movement from 1988 to

2006 along with major incidents both externally and internally.

The following are considered

development indicators of stock

market. (Figure 4.4) The market

capitalization of SET has return to

the pre-crisis level. In 1995, the

market capitalization was 135

billion USD and sunken to 22

billion USD during the crisis in

1997. Now the market capitalization

recorded 140 billion USD in 200653. Thailand market capitalization in 2006 accounted

for only 2% of Asia stock market exclude Japan, compare to 10% in the pre-crisis.

53 The World Federation of Exchanges

The Highest point (’93)

Open international account (’90)

Mexican Crisis (’95)

Black May coup violence (’92)

Baht was attacked. Floated the currency (’97)

September- 11 (’01)

Bird flu Tsunami (’04)

Pay back IMF. Credit rating upgraded (’03)

Source: The Stock Exchange of Thailand

Figure 4.3 Thailand Stock Market Fluctuation, 1988-2006

Figure 4.4 Market Capitalization of SET, 1990-2006

Source: The World Federation of Exchanges

31

Source: The Security Exchange Commission Thailand

Table 4.1 Percentage of stock offering value by sectors, 2006

Regarding the P/E ratio (Figure

4.5), the SET reached the highest

point in 1993 at 26.09 and sharply

dropped to 6.59 in 1997. Then it

reached the new low in 2001 at

4.92. In 2006, unlike Market

capitalization and turn over, P/E

ratio still has not gain back it’s level

before the crisis yet and recorded

around 8.1.

The growth in secondary market

turnover in 1990s can also be

considered as a sign of the capital

market’s development. (Figure

4.6)The total value of share

trading increased significantly

from 19 billion USD in 1991 to

72 billion USD in 1992. In 2006,

Thailand reached the highest

trading volume at 116 billion

USD54. In these numbers, Thai

individual investors recorded

11.6%, Thai institution investors

54.5% and foreign investors

accounted for 33.9%, which was a

considerable amount.

54 The Stock Exchange of Thailand

Business Sectors Percentage of

Offering Value

Banking

Energy and Utility

Property Development

Construction Materials

Communication

Others

32%

19%

15%

13%

10%

12%

Total 100%

Source: The World Federation of Exchanges

Figure 4.6 Stock market Turnover, 1990-2006

Figure 4.5 P/E ratios of the Stock Exchange of Thailand, 1990-2006

Source: The Stock Exchange of Thailand

32

Listed companies on the SET areconcentrated in five sectors. In 2006, top five sectors

accounted for 88% of offering value of issued equity are Banking, Energy and Utility,

property development, construction materials, and communication. This shows that the

SET is highly concentrated in those few main sectors, which create market dependence.

Moreover, these sectors are easily affected by economic crisis. Thus, broader sectors can

reduce the market dependence and lower overall market volatility.

4.4 Development Direction

As Thailand’s stock market is not yet developed and still have some deficiency in several

aspects regarding demand, supply and infrastructure, in order to allow the capital market

to strongly support Thailand’s economic growth, the Stock Exchange of Thailand has to

develop more by aiming to improve demand and supply of the market, and increase the

efficiency of market infrastructure.

On the demand side, SET is promoting investors education programs by explaining the

role of the stock market in the economy and its value as long-term investment and saving,

and at the same time, encourages them to utilize the opportunities to invest in the stock

market. This is because there are still large potential of saving pool that were in the bank

system, which is quite common in Asian cultures. As the savings of Thai household went

mostly to bank deposit rather than equity or other financial investment, it is an important

factor that holds back Thailand capital market development.

On the supply side, SET encourages listing of companies including both private sectors

and huge state-own enterprises such as electricity, transportation, and communication55.

This is because some of the biggest profitable companies still own by the government.

By promoting privatization, SET will not only provide more attractive companies listed

in the stock market but also help lessen the dependence on a few market sectors. The

privatization also enlarges the market capitalization and raises the efficiency of the public

55 Government has gradually privatized and listed a number of state own enterprises such as PTT Plc, Krung Thai bank, Thai Airway, International and Airport of Thailand, Electric Generating Authority of Thailand, The Mass Communication Authority of Thailand, TOT Corp and CAT telecom.

33

services for the economy. By attracting private company especially small and medium

sized firms that normally operate by debt financing, SET opened the Market for

Alternative Investments that allow SME to participate and also offer them tax incentive.

Moreover, SET established Capital Market Opportunity Center in order to provide

knowledge of opportunities companies get by listing in SET. Adding to that, SET has

improved its supply by promoting market transparency and information disclosure, and

corporate governance.

Last but not least, regarding infrastructure, SET tries to reduce clearing and settlement

risk, cut transaction cost and striving for better services for investors by launching

Internet trading system as well as regulations for the internet trading.

4.5 Foreign investors

According to The Bank of Thailand Report in 2006, countries that hold significant share

of Thai equity investment are United Kingdom(33.8%), The United States(20.2%),

Singapore(15.7%) and others(30.3%)56. The sector that receive the largest fund is

financial institution accounted for 30.9% of total foreign investment, followed by

manufacturing 19.2%, State owned enterprises 17%, services 13.7% and real estate 7.7%.

End of 2006, Non-residence holding Thai securities total around 42.3 billion USD.

Equity security investment accounts for 93.4 % of total investment.

4.5.1 Investment Alternatives for foreign investors

In general, foreign investors can trade freely on shares listing on the SET main board as

long as the foreign shareholding percentage does not exceed the limitation for specific

company. Else they are not entitled to register the share under their name. Another

alternative for foreign investors is trading on foreign board where securities will be

automatically registered under their name while they can still receive the rights and

dividends directly. If the foreign shareholding limit has been reach, brokers will put the 56 The numbers accounted for securities invested by foreign investors through local custodian, broker and sub-broker companies.

34

investors in a waiting list. The differences between trading in the main board and foreign

board is that, there is no ceiling price in the foreign board, thus price can freely fluctuate

regarding to demand and supply. Thus, share trading on foreign board can have price

premium when demands exceed supplies. Foreign investors can also invest through Thai

Trust Fund (TTF) operated by Thai Trust Fund Management Co., Ltd., one of the SET

subsidiaries. It offer open-ended mutual fund to foreign investor, while it can invest

beyond the foreign shareholding limit. In this case, investors receive all financial benefit

except voting rights and can avoid problem of foreign shareholding limitation. Another,

investment vehicle for foreign investors is Non-voting depository receipts. Investors will

receive the same benefits as trading normal stock except voting rights. NVDR eliminate

foreign investment barrier, specifically, the foreign shareholding limit. NVDR’s price is

the same as real time trading price of local share and investors can convert their holding

position from NVDR to securities.

4.5.2 Foreign Investment Regulation

Due to the control of capital inflow, the Bank of Thailand required 30% reserve of

foreign currency inflows. It said financial institution must withhold 30% of foreign

currency brought into Thailand for investment. Then, the reserve will be transfer to BOT

where it will be held for one year without interest. If the fund is withdraw earlier, only

two third of the reserve will be released. This regulation was imposed in December 2006

as a result of 15% baht appreciation that made Thai export to be less competitive and to

avoid currency speculators and short-term capital inflows. Consequently, the new reserve

policy triggered a sharp drop of 10% on the Stock market the next day. Due to the

damage on the Thai stock market and negative response of foreign investors, The Bank of

Thailand modified the rules to exclude portfolio on equity inflows for equity investment

in companies listed in the SET, the Market for Alternative Investment (MAI), the Thai

Future Exchange (TFEX), and the agricultural future exchange of Thailand (AFET).

35

4.6 The Stock Exchange of Thailand SWOT Analysis

Strengths

• Foreign individual investors can benefit from the tax exemption of capital gain from

investing in securities listed on the SET, where as foreign institutions are subjected

to 15% withholding tax. Withholding tax of 10% on dividends and and 15% on

interest income still applied.

• The value of Thai shares is considered inexpensive compare to other in the developed

economy. They are on the way forward of developing companies’ performances and

investors’ confidences to justify higher share prices. In other word, there is room for

the price to develop.

Weaknesses

• As Thailand Stock market is a developing market, it has relatively small market

capitalization, trading volume, number of listed companies, range of products of in

comparison to those of developed market.

• Moreover, the volatility of Thai market is considered high compare to those of

developed market. This is as well a general quality for most emerging stock market.

Thus, it imposes higher risk for investors

• Another weakness of Thai stock market is that it has lack of listed stock in some

sectors and the capitalization of listed companies are concentrated only in a few

sectors, especially those that can be highly affect by economic crisis.

• The listing Thai companies still need to cope with the issue of corporate governance,

information availability and transparency, in order to create investors’ confidence.

SET is also trying to cooperate with listing company and help them to improve these

matters.

Opportunities

• By realizing the fact that Thai business is based on the small and medium sized

enterprises, the SET established the Market for Alternative Investment. It is

expected that the MAI will attract more and more SMEs and have more listed

36

companies, thereby provide the Thai stock market with broader variety.

Threats

• Political uncertainty and political transition lead to policy changes and sometimes

lack of policy clarity. Unexpected changes can affect investors’ sentiments, which in

turn create fluctuation on the SET index.

• Even though the portfolio equity investments strengthen the growth of Thai stock

market, the increase in portfolio inflows into Thailand creates more volatility and

vulnerability to Thai economy. For instance, the inflows lead to appreciation of Baht,

which directly affect Thailand’s export competitiveness. Moreover, the fluctuations

of foreign stock market will have more influence since foreign investors tend to be

more naïve and sensitive than the local investors because they are less accessible to

the local situation57. In addition they can mobilize their fund and change their

portfolio composition according to the stock market movement.

57 Vichyanond et al, 2002

37

5 Portfolio Theory

To succeed, mutual fund managers must make sound investment choices and execute

them effectively. Portfolio management provides context for making decisions. It is a

process of managing group of assets (i.e. stocks, bonds and bank deposit) by making

decision about the investment including assets screen and selection, matching investment

with the objective or investors’ preferences, evaluating and maintaining portfolio

performance. The aim of Portfolio Management is to maximize return from a portfolio as

well as minimize risks in order to achieve efficient and effective allocation of scarce

resource which has been managed by an individual investors and financial institution

investors or fund managers.

In the previous chapters, we have discussed the role of mutual funds that has been

dramatically increasing in the emerging markets due to an upsurge of financial market

liberalization as well as globalization. Fund managers allocate their portfolio across

countries aiming to diversify their portfolio to achieve higher return and lower risk. They

need to take issues regarding characteristics of countries’ and stock markets’ including

economic and politic situation, stock market development and future directions in to

consideration. This is because this information is used for stock screening and selecting

countries and stocks that match the investment objectives. In this chapter, portfolio theory

used as a foundation of asset allocation fulfilling the role and the objectives of mutual

fund investment will be introduced. It will explain the fundamental of risk and return

characteristic of a portfolio, and the efficient frontier.

Portfolio Theory is one of the most important and influential economic theories that deal

with financial investment. The study of Portfolio Theory was introduced by Harry M.

Markowitz in 1952 with his paper “Portfolio Selection” in the Journal of Finance. He is

the first one who proved the benefit of diversification of equities portfolio

mathematically. He purposed the mean-variance framework that focuses on 2 elements of

risk and return of individual securities in constructing a portfolio. Moreover, by investing

more than one particular stocks i.e. in different countries, regions, and sectors, investors

can gain the benefits of diversification in terms of reduction in the risk of the portfolio

38

and a better return for the portfolio. These benefits of diversification is also known as the

famous saying, “Do not put all your eggs in one basket”. According Markowitz’s theory,

investors are allowed to construct portfolios that optimized expected return at a given

level of risk or efficient frontier of optimal portfolios.

By the initiative of Markowitz, his portfolio theory has been studied, expanded and used

as a foundation of portfolio investment decision. In 1958, James Tobin expanded

Markowitz’s portfolio theory by adding a risk-free asset to the analysis. By combining a

risk-free asset to a portfolio, it allows investors to leverage their portfolio by short selling

the risk-free asset and buy additional holding or de-leverage by selling some of their

holding in the portfolio and invest in risk-free assets. As a result, it improves portfolio

efficient frontier that fall on the capital market line. In 1964, William Sharpe published

the capital asset-pricing model (CAPM) that introduces the notions of systematic and

non-systematic risk. Systematic risk is the risk of the market that cannot be avoided by

diversification and it affects the entire market. As the market fluctuates, stocks will be

affects. Whereas non-systematic risk is the specific risk that can be diversified. Thus,

investors are exposed to systematic risk where they require premium or compensation for

it. Under CAPM, strict assumptions have to be applied, for example, no transaction costs,

all investors have identical investment horizons, identical opinions about expected

returns, volatilities and correlations of investments

5.1 Characteristic of Assets

In order for an investor to make decisions about their investment, they have to consider

the level of risk he or she is willing to bear. In general sense, investors want the highest

return at the lowest level of risk. However, the more return is demanded, the more risk

they have to bear. There are always trade off between risk and return. It is important to

fund managers to study the risk and return characteristic of the assets to facilitate their

securities selection process58.

58 As said earlier, making country and its stock market analysis help assess risk/reward.

39

In the nature of security return, it is bounded by uncertainty as price of securities

fluctuate over time. Funds managers need the ability to forecast future pay offs based on

historical data from stocks markets. The most common measure of the tendency of the

return distribution are a measure of central tendency, called an expected return, and a

measure of dispersion around the mean, called the standard deviation. The expected

return is calculated by finding the sets of outcomes with their associated probability of

occurrence or return distribution and assigning probability of occurrences to each return

because under risk, the outcomes are not known with certainty. Let Pij denotes probability

or a frequency function and Rij is possible return of asset, Thus we can calculate the

expected return,

!

E(Ri) , by,

!

E(Ri) =j=1

n

"PijRij (1)

It is not sufficient to only calculate the measure of return, but also a measure of

dispersion of the outcomes from the average, which make a great deal for portfolio

manager. In other words, it is the measure of volatility of the stock return. The most

common method to quantify risk is to use the standard deviation of the expect returns. It

measures the spread of values in the data set. If a value is far from the mean, it results in

high standard deviation. The greater the standard deviation or the greater the spread and

the greater the risk is. The standard deviation of ith asset is equal to;

!

" i =j=1

M

#(Ri $ E(Ri))

n $1 (2)

where

!

"i is the standard deviation of the return of asset i,

!

Ri is the return on asset i,

!

E(Ri) is the expected return on asset i, and n is the number of returns.

5.2 Characteristic of a Portfolio

For mutual fund manager, they do not hold just an individual security but a portfolio of

securities which call for the need of calculating expected portfolio return and portfolio

standard deviation. The expected portfolio return is simply the weighted average of the

return of individual assets. Where

!

E(Rp ) is the expected portfolio return,

!

Wi is

40

weighting of proportion invested in each security, and

!

E(ri) is the expected return of

respective security, a portfolio’s expect return is calculated by;

!

E(Rp ) = WiE(ri)i=1

n

" (3)

For measuring volatility or the riskiness of the portfolio return, it is more complex than

computing single security because when holding a group of stock portfolio , the risk of

the portfolio will be affected by how securities tend to move in relation to each other and

the level they move together. Thus, covariance or correlation of the return of each pair of

the securities in the portfolio should be measure. The more the securities return move

together, the more the risk is created to the portfolio. On the other hand, if the return

move opposite way, the less the risk will be. When,

!

" p is the standard deviation of the

return on the portfolio, W is the weights by which each asset is represented in the

portfolio,

!

covij represents a covariance between asset i and j,

!

"i

2 is a variance, portfolio

risk can be expressed by;

!

" p =i=1

N

#Wi

2" i

2+ 2

i=1

N

#j>1

N

#WiW j covij (4)

This shows that by adding assets with low or negative covariance to a portfolio, it will

reduce the sum of the covariance and therefore reducing the total risk of the portfolio.

This is referred to as “Diversification benefit”. Thus, it allows portfolio manager to

diversify away unsystematic risk of portfolio security, which will be explained in the next

part.

5.3 Portfolio Diversification

The concept of diversification is based on the saying “Do not put all your eggs in one

basket”. Diversification can help investors reduce risk by investing in different type of

assets, different asset locations or different industrial sectors where low correlation is

generally found, in order to limit their risk exposure. According to this paper, a mix of

investing in Thailand stocks, and other stocks from developed countries will be

examined. It is a case where the stocks in developing and developed countries provide

low correlation which there by investor can benefit from portfolio diversification. In

41

other words, let some of the fluctuation cancel each other out which will result in a higher

average rate of return for a given risk and lower volatility for given return.

In order to measure and prove the diversification benefits, two important factors need to

be examined. They are covariance and correlation coefficient. In portfolio investments, it

is necessary to know how the return of security for example x and y behave in relation to

each other which also implies the risk of the portfolio. Covariance measures the degree

the return of two risky assets move together. A positive covariance means that the return

of x rises at the same time that the return of y rises, whereas a negative covariance mean

that they move in an opposite way. If there is no relation in both x and y return movement

or they move independently, the covariance will be zero. Where x and y are two

investments, E(Rx) is the expected return of asset x and E(Ry) is the expected return of

asset y and n is the number of observation, covariance between assets x and y can be

illustrated by;

!

covxy =" xy =#[Rx $ E(Rx )][Ry $ E(Ry )]

n $1 (5)

However, the number representing covariance depends on the level of the data, thus it is

not meaningful to compare data sets that have different scales. Therefore, correlation

coefficient is used because it normalized the covariance to the product of standard

deviation of the variables that facilitate comparison of different data sets. It can be

calculated by;

!

"X ,Y

=cov(X,Y )

#X#Y

(6)

A positive correlation coefficient occurs when two stock returns move up and down

together and a negative correlation coefficient occurs when two stock returns move the

opposite direction. The correlation coefficient will be scaled down between -1 and +1. If

it is perfect positive correlation, correlation coefficient is 1 and if it is perfect negative

correlation, correlation coefficient is -1. According to the portfolio variance calculation

(4), it can be rewritten by replacing the covariance with correlation coefficient;

!

" p

2=

i=1

N

#Wi

2" i

2+ 2

i=1

N

#j>1

N

#WiW j$x,y (" x" y ) (7)

42

where the first term is the sum of weighted average of assets risk or volatility and the

second term is the sum of the respective weight in the portfolio share of correlation

coefficient and the products of the assets’ standard deviation. When there is very low or

negative correlation, the second term will be small or in negative which thereby reducing

the overall portfolio risk.

5.4 Evidence on International Diversification

In general, risk averse-investors would prefer less risk to more, they will try to reduce

their risk by diversifying portfolio risk and choose to invest in assets that have low

correlation toward one another to minimize the overall portfolio risk. In the international

stock exchanges, negative correlation might be rare, but low correlation in different

markets can be usually found. As the matter of fact that the market structures and

economies across the world have different degree of economic integrations, strengths and

weakness, the price and return movements fluctuate according to different factors and

also at different degree. Thus, investing in an international portfolio rather than domestic

portfolio has become crucial diversification instrument in portfolio investment as

international portfolio has lower risk due to lower correlation coefficient between stocks.

It creates oversea opportunities for fund manager to maximize returns while attempting to

lower their risk.

The trends in the financial market for the past 20 years has been increasing investment in

international markets that provide opportunities of portfolio risk reduction than what can

be achieved by a domestic investment strategy. There mare many researches has

documented the international diversification. Fletcher and Marshall (2005) examined the

benefits of international portfolio diversification for U.K. investors and found significant

increase in the Sharpe ratio and certainty equivalent return (CER)59 performance by

moving from a domestic strategy to international strategy, even in the presence of short

selling restrictions. In addition, the level of investor risk aversion affect the size and

benefits of diversification, particularly, the performance of Sharpe and CER are greater at

59 For more information how to calculate CER, please see in Fletcher and Marshall, 2005

43

a lower level of risk aversion. A research of Naranyo and Porter (2007) suggests that

diversification benefits are larger when adding emerging markets in an international

momentum trading portfolio investment strategy than when adding developed market

since emerging markets are less integrated than developed markets, thereby the

diversification benefit should be larger. The research of Driessen and Laeven (2006)

suggested that the benefit of diversification appear to be large for the countries with high

country risk or developing countries and it also vary over time as country risk changes. In

other saying, diversification benefits increase when the correlation of the investment

returns decrease. This is also supported by Gruble (1968), stating that when correlations

are sufficiently low such that the volatility and overall risk reduction through

diversification is large.

The statistical evidence on international diversification, market integration and the

correlation between markets has been widely documented. From many researches

conducted in different periods, it shows that the comovement or correlation of asset

returns vary overtime. In the early study, Grubel (1968) and Lessard (1973) find small

correlations across international equity markets due to the fact that there were only small

magnitude of integration and liberalization, which thereby leave the opportunities of

gaining from diversification benefits to investors. It encourages investors to invest

outside domestic market since international markets can offer more risk reduction than

the domestic market can offer. However, Goetzman (2002) study implied that the

correlation of the major world equity markets has been increasing and are especially high

during periods of economic and financial integration such as the late 19th and 20th centuries,

meaning that the diversification benefits invest is not constant over time and thus

investors can reduce their portfolio risk less than in the history. On the other hand,

market liberalization and integration allow investors to access international market or even

frontier market more easily, in so doing, investors are attracted by investing in the

emerging market where the correlation of returns are still low in comparison with the

developed market. This leads to this research about adding emerging market stock into the

portfolio investment that will enhance benefit of diversification.

44

5.5 International Investment and Currency Movement.

For the past decade, the benefits of international investment are put forward by the higher

return at a given level of risk or a lower risk given return than what domestic investment

can offer. In order to prove the benefit of international portfolio investment, there are 2

factors that we have to examine, namely; market correlations and currency movement.

As it has been shown in the previous section, the important factor determining the

portfolio risk is the correlation coefficient between the returns of assets that makeup a

portfolio. In this section, the effect of currency movement to portfolio mean-variance

analysis will be illustrated.

A key difference between investing in domestic and foreign assets is the latter exposed

the portfolio to currency risk. Hence, in order to invest in assets in foreign countries,

currency risk exposure becomes a crucial factor that has to be taking into account. It

makes the return and risk on a foreign investment differ from the return and risk on assets

in domestic market because both risk and return comprise of 2 part; namely, the risk and

return of domestic assets themselves and the risk and return of exchange rate. The return

of foreign stock can be calculated by;

(1+RD) = (1+Rx)(1+RF) (8)

Where RD denotes return on stock in domestic currency, Rx denotes return on exchange

rate and RF denotes the return on stock in foreign currency, the return measured in

domestic currency is the return of stock in foreign market plus exchange gain or loss.

When domestic currency appreciate (depreciate) against foreign currency at a given

foreign asset return, it reduces (increase) the return of foreign investment measured in

domestic currency. Thus, the return on a foreign investment can be quite different than

simply the return in the asset’s own market and can differ according to the domicile of

the investor60. This makes the benefit of diversification differ across countries. We also

have to take exchange rate factor in standard deviation property. Hence, the standard

deviation of return can be calculated by;

!

"D

= "x

2+"

F

2+ 2"

F ,x (9)

60 Elton et al. 2007

45

where σD represents standard deviation of domestic return, σx represent the standard

deviation of exchange rate gain/loss, σF represents the standard deviation of foreign asset

return and σF,x is the correlation between the movement of foreign asset return and return

on exchange rate. The standard deviation of the return expressed in domestic currency is

considerably less than the sum of the standard deviation of the return on exchange

gain/loss and the standard deviation of the return of foreign assent in foreign currency. As

we can see, the risk increases due to exchange fluctuation and the correlation between the

exchange rate and the foreign asset return.

As the exchange rate factor become crucial because it can add negative and positive

effects to the return measured in domestic currency, we need to analyze how the expected

return in foreign countries would have to be in order to gain from international

diversification by taken both return and volatility of return in to account. Thus we will

invest in foreign asset when;

!

E(RF ) " Rf

#F

>E(RD ) " Rf

#D

$F ,D (10)

However, it is possible for investors to protect partially against the exchange rate

fluctuation by entering a future or hedging contract of currency exchanges at a known

rate in the future date. The reason that this method can partially protect investors from

exchange rate fluctuation is because it is still unknown how the currency will move in the

future in relation to the future contract rate, but it helps investors to protect themselves

against a particular outcome or the extreme outcome, for example, during the financial

crisis. The effect of hedging of the currency fluctuation reduces the risk because it

reduces the correlation among countries’ returns, Larsen and Resnick’s (2000) Research

suggested that unhedged international portfolio investment fail to provide superior

portfolio performance. Moreover, different hedging strategies give different magnitude of

return. Eun and Resnick (1988, 1994) has shown that it is important to control uncertainty

in order to capture the potential gains from international diversification and hedging the

foreign exchange risk can increase the gains from international stock portfolio

diversification.

46

5.6 Efficient Portfolio and Efficient Frontier

5.6.1 Markowitz’s efficient frontier

According to Markowitz, it is common for investors that they all desire high return. We

can assume that risk avoidance investors prefer more to less returns and they also desire

this return to be certain or stable over time. The less stable the return is, the more

uncertainty or the more risk investors have to face. Thus on the ideal basis, investors

prefer return to be high and certain. However, there is no guarantee that they can get

both. Some portfolios might offer very high returns but at high uncertainty or others offer

returns that are not subject to uncertainty but at undesirable rate. Those are the two

extreme ends. There are surely other mix in between which it depends on investors who

can choose portfolios with varying degree of certainty and return. This set is called

efficient set or efficient frontier. It shows a set of portfolios that offer the optimum return

for a given level of risk. The more return required by investors, the more risk that they

have to accept. In other words, if they have to face high risk, they would also require the

return to be high in regard of trade off between risk and return.

By using the level of return and risk, we can graphically illustrate the opportunity set for

the efficient frontier. According to Figure 5.1, the horizontal axis measure risk by using

the standard deviation, while the vertical axis measures return. In the least complicated

case, if there are 2 portfolios, for example portfolio B and D, which have the same level

Figure 5.1 Efficient frontier of portfolio of stocks

Return E(r)

C •

•

Efficient

Frontier

B

• A

Risk (σ)

D • Inefficient

Portfolio

47

of return, the one with lower uncertainty or less value of standard deviation is the

efficient portfolio which leave the other to be inefficient. The same as 2 portfolios with

the same certainty, namely portfolio D and A, investors certainly prefer portfolio D to A,

the one with higher return, since they prefer return to be more rather than less. Thus, we

refer this portfolio as efficient portfolio and another as inefficient portfolio. It is clear that

at a given value of standard deviation, investors prefer the highest return they can

possibly get. As shown in the graph, investor will choose the portfolio that lie along the

curve B to C, but not portfolio that lie under the curve. Thus, investors can now

distinguish between efficient and inefficient portfolios.

5.6.2 Efficient frontier with risk-free asset

Risk-free asset is an asset that its future return is known with certainty. It is usually

proxied by for example investing in the government securities or saving accounts. The

properties of risk-free asset are that returns are certain and has zero standard deviation,

which is not correlated with other investment assets. The expect return including both

risk-free asset and risky asset is given by61;

!

E(Rp ) =fR +

E(Ri) " fR# i

$

% & &

'

( ) ) # p

(11)

Where E(Rp) is the expected return on the portfolio of risk-free and risky assets, Rf is the

return of risk-free asset, E(Ri) is the expected return on risky asset, σ i is the standard

deviation of risky asset and σp is the standard deviation of the portfolio. This results in an

equation of a straight line. Thus, it creates a linear relationship where the combination of

a portfolio of risk-free and risky assets lies along it (figure 5.2). Investors will choose to

invest in a portfolio of a risky asset A and risk-averse investors will select a portfolio

along Rf and A by investing in a combination of risk-free and risky assets.

61 Elton et al. 2007, 86

48

5.7 Optimal portfolio selection

In general, an optimal portfolio is a portfolio that provides the greatest expected return

for a given level of risk, or the lowest risk for a given return, which has the same quality

as efficient portfolios. On the other, optimal portfolio can also be considered as an

efficient portfolio that is most preferred by investors because its risk/reward

characteristics approximate the investors, for example, utility function62, risk tolerance

function63, value at risk64 function, return to variability ratio, excess return to standard

deviation65 and so forth. As investors will be left with indefinite number of efficient

portfolio combinations that each of them provides trade off between risk and reward

level, investors have to choose one portfolio combination that match their criteria and

they most prefer.

62 Elton, Gruber, Brown and Goetzmann et al. 2007, 218 63 Elton, Gruber, Brown and Goetzmann et al. 2007, 220 64 Elton, Gruber, Brown and Goetzmann et al. 2007, 233 65 When the constant correlation is accepted as co-movement between stock returns do not changes, portfolios can be ranked by excess return to standard deviation ratio.

Return E(r)

Efficient Frontier

A

Risk (σ)

Figure 5.2 Efficient frontier with risk-free asset

Rf

•

49

6 Empirical Research

6.1 Data

In this analysis, the historical data series of Morgan Stanley Capital International (MSCI)

indices66 are used since it was constructed as benchmark indices including both

International Equity indices and Stand-Slone Country Indices that take into account of

foreign ownership limits and other restriction according to investment for international

institutional investors. The primary data source is monthly time series data on historical

price of MSCI stock indices collected from Thomson Datastream (TDS). The period

covers the year 1988 to 2006 as it is the year that emerging market start to gain

significance in the world stock market following the financial liberalization and reform.

Noted that these period includes major incidents that have impact on stock markets such

as the year of Mexican crisis in 1994, Asia financial crisis in 1997, the 2000 Internet

bubble burst in the United States and the terrorist attack on September 11th, thus these

market crashes will affect the results of this analysis.

The stock index used in this paper are MSCI World, MSCI emerging market, MSCI

Thailand, MSCI USA, MSCI UK, MSCI Japan, and MSCI Mexico. The reason that these

markets are chosen is due to the market significance, in particular USA UK and Japan.

However, the biggest emerging stock markets such as China and India are not included in

this analysis due to limitation of time series data. Hence, Thailand and Mexico are chosen

as both are gaining its investment destination popularity and this report particularly pays

attention to Thailand. Dividend, other incomes, taxes and transaction costs are not

incorporated in the calculation of portfolio return due to lack of continuous data. The

monthly data is used to calculate holding period returns, standard deviations and

correlation coefficients in order to increase the quality of data testing. According to the

fact that these markets have different characteristic regarding country specific that

contributed to stock risk and return, it will be very beneficial to perform analysis of each

country and its stock market as it has been done for the case of Thailand in the previous

66 The MSCI standard index series adjusts the market capitalization of index constituents for free float and target for index inclusion of 85% of free-float adjusted market capitalization in each industry group, in each country.

50

chapter which help understand specific characteristics that can affect the country stock

return and risk.

6.2 Method

In order to determine the benefit of diversification when adding emerging market stock in

a portfolio of developed market stock, efficient frontier of portfolio combination, and

optimal portfolio allocation using Mean-Variance portfolio theory initiated by Markowitz

discussed in chapter 5 are applied. To simplify the portfolio construction, 3 developed

countries indices; USA, UK, and Japan, 2 emerging countries market; Thailand and

Mexico, World Index and Emerging Market Index are included in the portfolio

calculation. The analysis provides short-term and long-term time horizon results; the

short-term period is 1 year and the long-term period is 5 years. The assumption for this

analysis is that the portfolio managers apply buy and hold strategy, the portfolio is

managed passively and the stock prices are in the US dollar, thus the currency exchange

risk is not taken into consideration in this report.

In this analysis, arithmetic mean return will be used in mean-variance portfolio

calculation. According to McCoulloch (2003), he stated that arithmetic return provides

more relevant and correct result in portfolio analysis. This is because portfolio geometric

return is not a weighted average of the geometric return of the underlying assets and it

understates the expected portfolio size67. Returns are calculated by using holding period

return. To calculate holding period return, when R is a holding period return, Pt is the

price at the end of year, and P0 is the price at the beginning of year, holding period return

of 1-year and 5-years are given by,

!

R = (Pt" P

0

P0

) #100

Moreover, 1-year and 5-year holding periods are assume to be true investment horizon,

hence 1-year and 5-year terminal holding period returns are used in calculating optimal

portfolio weight instead of using for example annualized 5-year holding period return. 67 The test between geometric return and arithmetic return in portfolio analysis can be found in “Geometric Return and Portfolio Analysis”, McCulloch (2003)

51

The aim is to avoid systematic bias in portfolio performance measurement in the case that

the true horizon is different from the horizon used in empirical research, which in turn

affect the portfolio selection. According to Levy (1972), it is mathematically showed that

if holding period returns used is longer than the true investment horizon, the portfolio

with the smallest risk (standard deviation) will have the highest Sharpe ratio and if

holding period returns used is shorter than the true investment horizon, it can be predicted

that portfolio with the highest risk will have the highest Sharpe ratio.

The efficient frontier and optimal portfolio calculation will be subjected to the

assumptions that (1) as mean-variance portfolio theory is a single-period model, investors

allocate their wealth at the beginning of the period and at the end of the period, his wealth

change at the weighted average return (2) investors are risk-averse and they prefer more

return for a given variance or prefer less risk for a given return (3) no riskless lending and

borrowing, (4) no short-sell allowed; investors will not assign a negative weight to any

assets, thus the minimum of investing is 0% and the maximum is 100% (5) finally, the

mean-variance portfolio theory is a solid tool for portfolio optimization in the case the

returns are normally distributed and constant correlation of returns are assumed in order

to predict expected returns from past return.

Thus, according to the Mean-Variance portfolio optimization, it creates the following

problem;

Minimize

!

" p

2=

i=1

N

#Wi

2" i

2+ 2

i=1

N

#j>1

N

#WiW j$x,y (" x" y )

Subject to: (1)

!

Wi" 0 i = 1, 2, …, N

(2)

!

Wi

i=1

N

" =1

(3)

!

(WiR ii=1

N

" ) = R p

52

This problem of portfolio optimization is solved by using quadratic programming

provided by “The Investment Portfolio Software”68, which will be used though out this

analysis.

6.3 Empirical Results

Table 6.1 present the world stock market capitalization. The table is divided into two part

which are developed countries and emerging economy countries. This shows that the

developed stock markets take a very significant part in the world stock market as they

represent 87.58% of the overall stock market capitalization, which leave 12.42% for the

emerging economy countries. The biggest player in the world stock market is USA,

accounted for 37.9%, follow by UK and Japan that account for 9.3% and 7.3% of the

world market capitalization accordingly. In contrast, the emerging economy stock

markets, China accounted for the biggest emerging stock market with 3.37% of the total

world capitalization. Mexico and Thailand recorded for 0.68% and 0.27% of world

market capitalization.

6.3.1 Summary Statistic69

6.3.1.1 Short-term

Table 6.2 shows summary statistic of 1-year holding period return of the selected stock

indices for the period 1988 to 2007. The mean returns in emerging markets are generally

higher than those in developed market over the period. In particular, Mexico and

Thailand indices reported an annual average return of 28%, and 11.7% in US dollar

terms. In contrast, USA, UK and Japan reported annual average return of 10.64%, 8.43%,

68 The Investment Portfolio Software is in accompany with the book Modern Portfolio Theory and Analysis. 69 Noted that statistic data is under normality assumption. The result from Eview show that return data in both 1-year and 5-year holding period are not normally distributed. Kurtosis (a measure whether data are peaked or flat), and skewness (a measure of symmetry of the distribution) of data show no sign that data are normally distributed, as in normal distribution kurtosis is equal to 3 and skewness is equal to 0. Appendix 10 presents histogram of data distribution of the historical return data from selected stock indices for both period.

53

Table 6.1 World Stock Market Capitalization, 2007

Country Exchange Market Capitalization

Percentage of Market Capitalization

Number of listing companies

Developed Countries USA Japan UK France Hong Kong Canada Germany Spain Switzerland Denmark, Sweden, Finland, Iceland Australia Italy Korea Netherlands Belgium Singapore Norway Greece Austria Ireland Israel Portugal Egypt Luxembourg New Zealand Cyprus Slovenia Malta Bermuda Total Emerging Countries China India Jamaica Brazil Mexico Malaysia Chile Turkey Russia Thailand Indonesia Philippine Colombia Argentina Hungary Peru Iran Sri Lanka (frontier market) Mauritius (frontier market) Total

American SE, Nasdaq, NYSE Osaka SE, Tokyo SE London SE Euronex Hong Kong Exchanges TSX Group Deutsche Börse BME Spanish Exchanges Swiss Exchange OMX Nordic Exchange70 Australian SE Borsa Italiana Korea Exchange Euronex Euronex Singapore Exchange Oslo Børs Athens Exchange Wiener Börse Irish SE Tel Aviv SE Euronex Cairo & Alexandria SEs Luxembourg SE New Zealand Exchange Cyprus SE Ljubljana SE Malta SE Bermuda SE Shanghai SE, Shenzhen SE, Taiwan SE Corp. Bombay SE, National Stock Exchange India JSE Sao Paulo SE Mexican Exchange Bursa Malaysia Santiago SE Istanbul SE Warsaw SE Thailand SE Jakarta SE Philippine SE Colombia SE Buenos Aires SE Budapest SE Lima SE Tehran SE Colombo SE Mauritius SE

19,568,972.5 4,795,823.1 3,794,310.3 2,428,252.1 1,714,953.3 1,700,708.1 1,637,609.8 1,322,915.3 1,212,308.4 1,122,705.0 1,095,858.0 1,026,504.2 834,404.3 779,542.7 396,168.0 384,286.4 279,910.4 208,256.1 192,770.3 163,269.5 161,731.7 104,187.3 93,496.4 79,513.6 44,816.5 16,157.8 15,181.7 4,503.5 2,703.5 45,181,819.8 1,740,114.2 1,592,994.2 711,232.3 710,247.4 348,345.1 235,580.9 174,418.8 162,398.9 148,775.1 140,161.3 138,886.4 67,851.7 56,204.3 51,240.1 41,784.1 40,021.6 36,314.6 7,768.9 4,958.5 6,409,298.4

37.93 9.30 7.35 4.71 3.32 3.30 3.17 2.56 2.35 2.18 2.12 1.99 1.62 1.51 0.77 0.74 0.54 0.40 0.37 0.32 0.31 0.20 0.18 0.15 0.09 0.03 0.03 0.01 0.01 87.58 3.37 3.09 1.38 1.38 0.68 0.46 0.34 0.31 0.29 0.27 0.27 0.13 0.11 0.10 0.08 0.08 0.07 0.02 0.01 12.42

6,005.0 2,883.0 3,256.0 730.0 1,173.0 3,842.0 760.0 NA 348.0 791.0 1,829.0 311.0 1,689.0 224.0 205.0 708.0 229.0 290.0 113.0 70.0 606.0 51.0 595.0 260.0 182.0 141.0 100.0 14.0 54.0 27,459.0 2,114.0 5,952.0 389.0 350.0 335.0 1,025.0 246.0 316.0 265.0 518.0 344.0 240.0 94.0 106.0 41.0 221.0 320.0 237.0 63.0 13,176

51,591,118.2 100.00 40,635.0

70 OMX Copenhagen, OMX Helsinki and OMX Stockholm have integrated OMX in 2005, OMX Nordic Exchange includes Copenhagen, Helsinki, Iceland, Stockholm, Tallinn, Riga and Vilnius Stock Exchanges

Source: The World Exchange Federation

54

and 2.48% accordingly. Moreover, the World Index average annual return is 7.81%,

which is lower than 15.6% from Emerging Market Index. Due to the fact that developed

markets is very big and account for the main world market capitalization, the returns of

developed stock markets is averaged closer to the World Index than emerging stock

markets.

The indicator of risk is Standard deviation. The standard deviations of Thailand, Mexico

and emerging market indices are higher than USA, UK, Japan and World indices. This

bexplains the return in emerging market fluctuate or spread from its mean more than

those in the developed market. In other word, emerging market stock impose more risk to

investors than developed market stocks do. Unlike the developed countries, emerging

economy face instability of the political and government, threat of policy changes,

exchange controls and so forth, that affect to business performances and investors

sentiment which thereby are translated into the high standard deviation.

Table 6.2 Descriptive Statistic of 1-year Holding Period Return, 1988-200771

Thailand USA UK Japan Mexico World

Emerging

Market

Mean 11.70 10.64 8.43 2.48 28.28 7.81 15.60

Median 11.27 10.88 9.64 0.60 27.64 11.03 15.36

Standard Deviation 42.56 15.30 14.13 25.18 40.20 14.17 27.77

Sample Variance 1811.52 234.21 199.52 634.14 1615.72 200.82 771.30

Kurtosis 0.93 0.19 -0.37 -0.14 0.79 0.07 -0.63

Skewness 0.45 -0.47 -0.16 0.58 0.36 -0.68 -0.02

Range 244.39 74.52 70.81 126.44 239.28 73.10 128.77

Minimum -74.40 -27.99 -24.62 -44.09 -63.30 -29.47 -51.42

Maximum 169.99 46.53 46.20 82.35 175.99 43.62 77.35

Return to

Variability Ratio

0.27 0.70 0.60 0.10 0.70 0.55 0.56

Sharp Ratio 0.16 0.37 0.24 -0.10 0.58 0.21 0.38

71 All descriptive statistic of both 1-year and 5-year holding period are calculated by Eview.

55

Table 6.3 Descriptive Statistic of 5-year Holding Period Return, 1988-2007

Thailand USA UK Japan Mexico World

Emerging

Market

Mean 50.73 66.94 41.68 169.10 -0.98 40.60 72.01 Median 54.25 63.92 37.35 69.57 -8.21 36.57 48.18 Standard Deviation 114.70 67.87 43.09 263.86 34.10 41.82 99.67 Sample Variance 13156.53 4605.81 1857.08 69621.79 1162.68 1749.01 9933.46 Kurtosis -1.17 -0.52 -0.78 1.25 4.26 -1.09 -0.16

Skewness 0.28 0.55 0.11 1.30 2.19 0.18 0.78

Range 429.94 258.36 172.54 1294.06 153.11 159.37 418.84 Minimum -88.74 -25.22 -42.11 -50.39 -46.82 -29.44 -48.11 Maximum 341.20 233.13 130.43 1243.67 106.30 129.93 370.73 Return to Variability

Ratio 0.44 0.99 0.97 0.64 -0.03 0.97 0.72

Sharp Ratio 0.40 0.91 0.85 0.62 -0.18 0.85 0.67 Annualized Mean72 8.55 10.79 7.22 -0.20 21.89 7.05 11.46

Annualized Standard

Deviation73 51.3 30.35 19.27 15.25 118 18.70 44.57

6.3.1.2 Long-Term

In a 5-year holding period (Table 6.3), The returns and standard deviation in emerging

markets still maintain relatively higher than the developed market, except for Thailand

that has lower return, but higher standard deviation than the US. Moreover, developed

markets show higher return to variability ratio and Sharpe ratio than emerging markets

and they are higher in 5-year holding period compare to 1-year holding period. In order to

compare the return and standard deviation between 1-year and 5-year holding period, the

annualized 5-year holding average returns and annualized standard deviation are

calculated, however 5-year holding period return and standard deviation will still be used

in the portfolio allocation calculation in the later section. In 5-year holding period, the

annualized returns are slightly lower than 1-year holding period return except for USA.

Annualized standard deviation of 5-year holding return are in general higher than in 1-

year holding period except for Japan. This result is opposite to many research that

72 annualizing a return is: Ra = (1 + Ru)(1/n) - 1, where Ra equals the annualized return, Ru equals the unannualized return, and n equals the number of years over which the cumulative return is calculated 73 Annualized standard deviation = Standard deviation * (1/N)1/2, where N is number of years in calculation

56

support mean reversion saying that in the long term risk will cancel out each other

because return will move back to its mean, thus risk should be lower in a longer

investment horizon. There are still long debates whether returns follow a random walk or

mean reversion. In short, returns from the sample stock indices in this research are higher

in emerging market and in short-term period and fluctuate more in emerging markets and

in longer period.

6.3.2 Correlation Analysis

Another factor that contribute to the portfolio risk is correlation between individual

security returns. At this point, it makes emerging markets interesting as it is often that

including emerging market with developed market stock in a portfolio can reduce

portfolio risk due to the low and negative correlations. According to equation (4) in the

theoretical part, low or negative covariance of the portfolio reduces the overall risk of the

portfolio. Table 6.4 and 6.5 show the correlation values of 1-year and 5-year holding

period return between selected countries indices, World Index and Emerging Market

Index. The average correlation for 1-year holding period return is 0.57, whereas it records

0.46 for 5-year holding period return.

Table 6.4 Correlation Coefficient, 1-Year Holding Period Return

Thailand USA UK Japan Mexico World EM

Thailand 1.00

USA 0.00 1.00

UK 0.04 0.77 1.00

Japan 0.51 0.32 0.30 1.00

Mexico 0.27 0.27 0.33 0.21 1.00

World 0.22 0.85 0.79 0.70 0.27 1.00

EM 0.69 0.25 0.36 0.62 0.68 0.51 1.00

57

Table 6.5 Correlation Coefficient, 5-Year Holding Period Return

Emerging economies; namely, Thailand and Mexico are highly correlated to Emerging

market index, but show weak to negative correlation to the World index in both short-

and long-term period as emerging market is accounted for only a small fraction of the

world market capitalization. The correlation between Thailand and Mexico is week for 1-

year holding period, but increase in 5-year holding period. In contrast, develop

economies namely, USA, UK and Japan are highly correlated to the World Index for both

holding period and only Japan that unexpectedly show low correlation to the World Index

in the 5-year holding period. In addition, USA return is highly correlated to UK, but not

Japan. Referring to the co-movement of return between developed and emerging market,

Mexico return show weak correlation to returns in developed economies such as USA,

UK, Japan. Though Thailand return is not correlated to USA and UK return, but show

moderate correlation to Japan (around 0.5) in both holding period as close relation is in

regard of strong economic influences within the region that dilute the diversification

opportunity. Noted that Japan return is fairly correlated to Emerging market Index unlike

USA and UK that show weak return co-movement with the Emerging market Index in

both holding period

In general, the correlation between emerging market and developed market suggest

diversification opportunities due to low to negative correlation. The reasons that explain

the low to negative correlation are the degree of economic integration between countries

that affect the return movement. Thus, countries in the same continents that have closer

economy and industrial such as Thailand and Japan tend to have higher correlation,

Thailand USA UK Japan Mexico World EM

Thailand 1.00

USA -0.47 1.00

UK -0.12 0.84 1.00

Japan 0.55 0.00 0.36 1.00

Mexico 0.61 -0.09 0.02 0.06 1.00

World -0.25 0.90 0.94 0.39 -0.12 1.00

EM 0.90 -0.18 0.19 0.64 0.72 0.06 1.00

58

though one of them is categorized as emerging market and another as developed market.

However, it is not the case for Mexico and USA that has close economic integration and

it surprisingly show low correlation. Forbes and Rigobon (2002) explained that in the

normal period returns from Mexican and US stock market show only 10% cross-market

correlation, whereas in the high volatility or in crisis period, the correlation increase to

70%. Therefore, the result suggests that greater international diversification is obtained

by employing contracts of stocks indexes in different continents and have low degree of

economic integration.

6.3.3 Diversification Benefits of Including Emerging Market Stocks

There are many researched that have proved the diversification benefit of portfolio

construction moving from domestic strategy to International strategy by including other

developed market stocks in a portfolio (Fletcher and Marshall 2005). At the same time

the correlation of the major developed markets has increased due to economic integration

and globalization. Investing in emerging markets can expand the opportunity of

diversification as emerging stock market have shown high return and low market

correlation to the developed market regardless of high risk. Moreover, researches have

shown that the diversification benefit can be extended from including emerging market in

to international strategy (Naranjo and Porter 2007) as international strategy usually

include only developed country stocks. Due to the significance of developed stock

markets in the world market capitalization, investors may overlook emerging stock

markets. Thus, this section will focus on including emerging market stock in to a

portfolio of developed market stock compare to the international strategy that only

include developed market stocks in a portfolio. It can be argued that investors from

developed market can greater diversify by constructing a portfolio focusing on developed

market and emerging market than constructing an international portfolio consisting only

developed country stocks.

To simplify this, an efficient frontier of 3 types of portfolios will be compared; a portfolio

of developed market stocks only, a portfolio of emerging market stocks only, and a

59

portfolio including both developed and emerging market stocks. According to our sample

countries, A portfolio combination of USA, UK and Japan stocks represents developed

market stock portfolio, a portfolio combination of Thailand and Mexico represents

emerging market stock portfolio, and the combination of USA, UK, Japan, Thailand, and

Mexico represent a portfolio mix that includes both developed and emerging market

stocks For all feasible portfolios, investors with the same risk preferences will considered

only a portfolio that maximize expected return at a given level of risk or minimize risk at

a given level of expected return.

From figure 6.1, the horizontal axis represents risk in terms of standard deviation and the

vertical axis represents expected return. The result shows that the possible portfolios of

developed market stocks that lie on the efficient frontier (blue line) yields lower

risk/return, in contrast to efficient frontier portfolios including only emerging markets

stocks (red line). This is not surprising as investors are generally imposed to higher risk

when investing in emerging markets due to the fact that instability of finance, economic

as well as politic have high influence on the stock price fluctuations. However, when

including stocks from both developed and emerging markets in the portfolio (black line),

the efficient frontiers lie above both the efficient frontier of developed market portfolios

and the efficient frontier of emerging market portfolios. This means that investing in only

Efficient Frontier of Developed market Stock portfolio

Efficient Frontier of Emerging market stocks Portfolio

Return

Standard Deviation

Figure 6.1 Efficient Frontier of developed market portfolio, emerging market portfolio and a portfolio combination of both developed and emerging market stocks.

Efficient Frontier of a portfolio mix of developed and emerging market stocks

60

developed market stocks or emerging market stocks are inefficient investment choices

because by investing in either developed market stocks or emerging market stocks

investors get less returns while facing the same level of risk than investing in a portfolio

combination of developed and emerging market stocks. Noted that the efficient frontier

of these portfolio result relatively the same in both 1-year and 5-year holding periods

except for that in 5-year holding period, the level of standard deviation and return are

higher than in 1-year holding period (appendix 11).

6.3.4 Efficient Frontier and Corner Portfolios

This section is aiming at constructing a portfolio combination of developed markets and

emerging markets stocks from 5 sample countries; namely USA, UK, Japan, Thailand

and Mexico. Figure 6.2 and 6.3 provides efficient frontier (without riskless lending and

borrowing and no short sale allowed) and each portfolio asset as a separate investment for

1-year and 5-year holding period. Only, USA, UK, Japan, Thailand and Mexico returns

are used in calculated efficient frontier. The World and emerging market indexes are

presented for statistic comparison purpose. As the vertical axis represents expected return

and the horizontal axis represent risk in term of standard deviation. It is obvious that the

efficient frontier for the long-term holding period has higher return and standard

deviation than the short-term holding period as explained earlier that 5-year holding

period returns instead of annualized returns are used in the calculation. From the figures,

it is obvious that countries with low returns impose low risk to investors and countries

with high returns, impose higher risk. However, if we look at each country as individual

investment, in the short-term, Thailand and Japan seem to be inefficient assets due to

there are other assets that give higher return while at the same time have lower risk i.e.

USA and UK have higher return and lower risk than Japan and the same for Mexico that

has higher return and lower risk than Thailand . In the long-term, only Thailand that has

lower return and higher risk compare to USA. Hence, if investors have to choose

individual assets to invest, Thailand and Japan might not be an attractive investment

compare to others. However, by investing in combination of countries, Thailand still

yeild higher return than USA, UK and Japan in the short-term and higher than UK and

61

Japan in the long-term, though it has high standard deviation. Thus, in portfolio

calculation, Thailand still take part in the portfolio weight.

Figure 6.2 Efficient Frontier, 1-Year Holding Period

Figure 6.3 Efficient Frontier, 5-Year Holding Period

62

As the number of efficient portfolios is infinite, we can identify all efficient set of

portfolios by corner portfolios. A corner portfolio is a portfolio on the efficient sets that

differs to the adjacent corner portfolio with different portfolio combination. When

moving from one corner portfolio to the next, there is another asset to be removed or

added to the portfolio combination. Table 6.6 and 6.77 present weight percentages of

each corner portfolios of Markowitz mean-variance analysis as risk and return change,

return to variability and Sharpe Ratio for 1-year and 5-year holding period. Six corner

portfolios was generated in 1-year holding period and eights in 5- year holding period.

The first corner portfolio is the minimum variance portfolio, where the portfolio return

and standard deviation is the lowest and it also creates the lowest return to variability and

Sharpe ratio in both periods. The last corner portfolios are portfolios that give the highest

return as well as risk in terms of standard deviation, however the return to variability and

Sharpe ratio are not maximized and the portfolios consist of only one assets which are

holding Mexico stock for 100%.

In 1-year holding period, Thailand and Japan have small share of the portfolio weight

around 6.34%-8.86% and 2.27%-5.62% as discussed earlier that both countries are

considered to have low return and high risk in relative to USA, UK and Mexico. Further

more, weight for Mexico increases from 1.61%-100%, as portfolio return and standard

deviation increase till the highest point. In 5-year holding period, Thailand and Japan

gain their significance in the portfolio weight to around 17.61% - 37.64% and 32.51%-

78.32% accordingly, where as UK weight drop from around 51.33% - 57.94% in 1-year

period to 0.01% - 5.20%. Annualized portfolio return and standard deviation of 5-year

holding period are as well calculated in comparison to the portfolio return and standard

deviation of 1-year holding period. Result show that portfolio returns of 1-year holding

period are generally higher than annualized portfolio return of 5-year holding period,

while portfolio standard deviations of 1-year holding period are lower than annualized

portfolio return of 5-year holding period. However, unannualized portfolio return and

standard deviation of 5-year period give higher return to variability ratio and Sharpe ratio

than 1-year period.

63

Table 6.6 Corner Portfolio, 1-year Holding Period

Corner portfolio 1 2 3 4 5 6

Thailand 7.02% 8.33% 8.86% 6.24%

USA 29.43% 34.71% 38.21% 69.79% 47.32%

UK 57.94% 54.70% 51.33%

Mexico 1.61% 23.97% 52.68% 100.00%

Japan 5.62% 2.27%

Total 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Portfolio return 8.97 9.33 9.88 14.93 19.93 28.28

Portfolio Standard

Deviation 13.09 13.12 13.21 16.82 24.13 40.11

Return to Variability 0.69 0.71 0.75 0.89 0.83 0.71

Sharpe Ratio 0.30 0.33 0.37 0.59 0.62 0.58

Table 6.7 Corner Portfolios, 5-year Holding Period

Corner portfolio 1 2 3 4 5 6 7 8

Thailand 17.67% 30.65% 31.61% 31.64%

USA 20.45% 22.61% 44.62% 64.16% 68.16% 68.36% 77.27%

UK 0.01% 5.39% 5.20% 5.18% 0.23%

Mexico 1.23% 2.25% 22.73% 100.00%

Japan 78.32% 69.75% 32.51%

Total 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Portfolio return 15.00 20.50 40.69 60.66 61.76 61.81 90.16 169.10

Portfolio Standard

Deviation 30.17 30.55 35.22 42.85 43.36 43.49 75.65 263.13

Return to Variability 0.50 0.67 1.16 1.42 1.42 1.42 1.19 0.64

Sharpe Ratio 0.33 0.51 1.01 1.30 1.31 1.31 1.13 0.62

Annualized Portfolio

return 2.83 3.80 7.07 9.95 10.10 10.10 13.72 21.89

Annualized Portfolio

Standard deviation 13.49 13.66 15.75 19.16 19.39 19.45 33.83 117.68

If we assumed that return to variability or Sharpe ratio are unbiased portfolio

performance measurement, the optimum portfolio will be the portfolio that maximize

return to variability ratio and Sharpe ratio. The optimum portfolio combination that

maximize return to variability ratio in 1-year holding period is constructed of Thailand

6.24%, USA 69.79%, and Mexico 23.97 % (Return to Variability=0.89) and Thailand

64

28.93%, USA 69.35%, and Mexico 1.72% (Return to Variability=1.43) if holding the

portfolio for 5 years74. In addition, the optimal portfolio combination that maximize

Sharpe Ratio is construct of USA 46.93% and Mexico 53.07% (Sharpe ratio=0.62) for 1-

year holding period, in contrast to holding Thailand 27.84%, USA 69.65% and Mexico

2.52% (Sharpe ratio=1.32) for 5-year holding period.

7 Other consideration

Markowitz’s Mean-Variance portfolio theory is a very efficient assets allocation and

portfolio optimization tools that are widely used by investors. However, there are other

factors that should be taken into consideration when using it.

7.1 Market Condition

As mean-variance method requires only very few inputs, namely return, standard

deviation and correlation coefficient, these data is treated as a population of parameter.

Therefore, it is very important that the mean and standard deviation of return should be

the right measure of return and risk that reflect the market condition. Therefore, inputs

should be adjusted to reflect sound market condition and future condition. Change in

inflation rate affects directly to purchasing power and thereby it can affect investors’

investment choices75 because investors need to allocate their wealth for their

consumption, investment and saving. In a long investment horizon, it is important to

considered how inflation rate affects investors investment choice because they will care

more about their purchasing power value from the portfolio rather than a nominal value

as n the period of high inflation, investors are left with lower purchasing power giving the

portfolio value. Thus, investors can use inflation-adjusted return when optimizing their

portfolio. Another way to protect investors from inflation is to invest in other asset

classes that are correlated with inflation like Treasury bill76. When inflation is high,

74 Only optimal portfolio that maximizes return to variability ratio in 1-year holding period is a corner portfolio (no.4) in table 6.6. The rest of the optimal portfolios that maximize return to variability and Sharpe ratio are not a corner portfolio, hence the portfolio combinations are not shown in table 6.6 and table 6.7 75 Elton, Gruber, Brown and Goetzmann et al. 2006, 89 76 Elton, Gruber, Brown and Goetzmann et al. 2006, 89

65

treasury bill have a larger return and when inflation is low, treasury bill have a lower

return, However, treasury bill is just a partial hedge against inflation.

Taxation on various return including capital gains, dividend, and interest is also another

issue that investors should bear in mind when it comes to international portfolio

investment. As tax can vary from countries to countries, some types of investor and some

returns are tax exempted and some are not, it will be beneficial for investors to have a

good understanding of taxation rules in different countries.

7.2 Portfolio Rebalancing

This report was limited to only a single-period model that wealth is allocated at the

beginning of the period to a portfolio combination of assets. At the end of the period, the

weights of each assets class in the portfolio changes. The changes in values of securities

due to market fluctuation result in change in weights in a portfolio. The wining stock will

gain more significance in the portfolio weight, while the losing will loose its significance

in the portfolio weight. In international portfolio allocation, markets that experience bull

period will increase it weight in the portfolio, while the opposite is true for markets in

bear period. Thus, portfolio rebalancing is very important to investment or fund policy.

As each portfolio have specific objectives that match with specific risk level, by

rebalancing a portfolio, fund manager can bring the proportion of the portfolio back to

the target. Hence, it allows fund manager to maintain the risk level as well as minimizing

unnecessary risk. Moreover, investment time horizon affects portfolio-rebalancing

strategy. A long investment time horizon portfolio is likely to be rebalanced, whereas a

short investment horizontal is unlikely since there is less time for changes and portfolio

rebalancing comes at a cost.

7.3 Market timing

Some investors try to predict the future movement of market prices and make decisions

when is the best time to buy and sell stock. It is a widely used practice in actively

managing portfolio strategy. The aim is to buy when the price is low and to sell when the

price is high. Long-horizon investments are more like to use market timing due to returns

66

are more predictable in the long-run in relative to short-run referring to slow mean

reversion of return77. In addition, Short-horizon investors hold more cash and bonds than

long-horizon investors, therefore the benefit of market timing is small in the short-term.

There are still long debates whether the market timing strategy can beat the market and

better than buy-and-hold strategy. On one hand, many researches suggest that active

timing portfolio yield better return and lower risk beyond buy-and-hold strategy (Jensen

and Mercer (2003), and Brocato and Steed (1998)). On the other hand, other researches

(McDonald and Osborne (1974), Butler, Domain, and Simonds (1995)) argue that

market-timing strategy exposes investors to higher portfolio risk and high transaction cost

which stop portfolio manager from retain profit. Importantly, the fact that it is very

difficulty to predict future return accurately makes market-timing strategy become less

possible.

77 Ait-Sahalia and Brandt et al 2001, 1332

67

8. Conclusion

The dynamic growth in emerging market for the past decades both in terms of its

economic and stock market have fueled the economy following the year of financial and

economic liberalization. The high growth that outperformed many developed stock

markets and increase in accessibility has attracted foreign investors to allocate their

portfolio to the region. In addition, as developed economies become more and more

integrated and correlation of return have increased, investing in emerging market can

expand the diversification opportunity for portfolio managers. This brings the attention of

diversification benefit that investors can achieve by including emerging market stocks in

their portfolio according to Markowitz’s Mean-Variance portfolio theory. Although

investing in emerging market stocks expose investors to higher risk and high return, low

correlation to developed market can be experienced that help reduce overall portfolio

risk. With this characteristic of emerging market stocks, it can be argue that including

emerging market and developed market stocks in a portfolio helps investor improve

return for a given risk and lower overall portfolio risk for given return.

Mutual funds are investors in focus of this thesis since mutual funds are primary

institution investors that invest in portfolio of stocks and play an important role in

contributing their fund flows to emerging markets. A mutual fund is considered a

management investment company that is further classified as open-end fund. It channels

investors’ funds and saving to invest in various investment vehicles including stock,

bond, and money market. In the world financial markets, mutual funds have shown

considerable growth from $11.76 USD in 1999 to $21.76 USD in 2007. Mutual funds

assets contribute 48% of their total assets to stocks, 18% to money market, 18% to bond,

10% balanced/mixed and 6% to other assets. 52% of total mutual fund assets accounted

for America, 36% for Europe and 12% for Asia. The benefit of portfolio diversification

and professional portfolio management among other things have attracted more investors

such as pension fund as well as households that reduces their reliance on bank deposit

and increase their reliance on mutual funds. So far, the US mutual fund is the largest

mutual fund market in the world and its mutual fund flow contributed to emerging market

in considerable size.

68

In order for mutual fund manager to make investment decision to allocate part of a

portfolio to emerging market, it is essential that they take into account of a country’s

strengths, weaknesses, opportunities and threats in terms of economic, finance, politics as

well as its stock market into consideration since each country has different characteristic

that contribute to the fundamental of stock market risk and return. This paper purpose

Thailand as a case study. Like other developing country, Thailand has been trough major

financial market liberalization and deregulation since late 1980’s. Following the

liberalizations it experienced large capital inflows that keep pouring into the country

especially short-term inflows. These short-term inflows accompanied with weak financial

sectors and lack of strong regulatory framework had contributed to the fragility in

macroeconomic condition and led to Thai financial crisis in 1997. Today, Thailand is said

to be recovered from the 1997 Financial Crisis. Its GDP growth is expected to be around

4.6%, while high-income countries GDP is expect to be around 2.3% in 2008. Thailand

has run a moderate current account surplus since the crisis. International reserve has

increase as well as external debt tend to decline. Banking sectors are more aware and

show better performance. However, Thailand’s weaknesses are high dependency of its

economy on export accounting for 60% of GDP and the political situation that question

the country’s long-term perspective including capital control and foreign investment

regulations. These affect to investors sentiment and have negative effect on investment

allocation. The country is also threatened by increase in oil price that slow down the

economy and Baht appreciation that hurting its export.

Before 1997, business relied on bank financing 5 times more than stock market

percentage of GDP. Since the crisis, the economy rely more and more on financing from

capital market until 2003 that the stock market gained it significance more than bank

financing, while debt instrument financing remain the lowest. The major boom in Thai

stock market started since 1990 following the financial liberalization and reform. The

boom reached the highest point at 1683 in 1993. In 1997 crisis following the devaluation

of Baht, SET index dropped to 372 points. Presently, SET market capitalization has

returned to the pre-crisis level and has greater market turnover. The strengths that help

SET position itself in the world stock market is that SET offers foreign individual

69

investors tax exemption from capital gain, while foreign institutions are subjected to 15%

withholding tax on capital gain and 10% withholding tax from dividend. In addition as

Thai stocks are considered inexpensive and with the expectation of better performance in

the future, there is still room for price to develop. In the future, it is expected that Market

for Alternative Investment (MAI) will attract more SMEs, the foundation of nature Thai

business, which will provide Thai stock market with broader variety and more listings.

As SET is a developing stock market, there are some weaknesses such as small market

capitalization, small rage of products, issues of corporate governance, transparency and

information availability. Furthermore, like other emerging stock market, the market has

high volatility imposing higher risk to investors. Recently, there are Political uncertainty

that negatively contributed to fluctuation on the SET index that affect direct to investors’

sentiment.

To prove the benefit of portfolio diversification by including emerging market stocks into

a portfolio of developed market stocks, this paper employs Markowitz’s Mean-Variance

Portfolio Theory, a single period model, under assumption that no short sell allowed, no

risk-free assets, returns are normally distributed, and correlation of returns are constant.

In nature, investors prefer higher return for a given risk and prefer less risk for a given

return. Efficient frontier shows portfolio sets that optimize return for given risk and by

moving along the efficient frontier, investors face trade off between risk and return.

Data source is monthly data of historical stock index price of MSCI indices collected

from Thomson Datastream (TDS). The period covers the year 1988 to 2006. The indices

used in this research are MSIC World, MSCI Emerging Market, MSCI Thailand, MSCI

USA, MSCI UK, MSCI Japan, and MSCI Mexico. Dividend, other income and

transaction cost are not incorporated in the return calculation due to lack of continuous

data.

The descriptive statistic confirms that in both 1-year and 5-year holding period, in general

Emerging market stocks; Thailand, Mexico and Emerging market Index, give higher

return as well as higher standard deviation than develop market stocks; USA, UK, Japan,

70

and World index. Moreover the return to variability ratio and Sharpe ratio are higher in

developed markets than emerging markets. The annualized returns of 5-year holding

period are slightly lower than 1-year holding period return while standard deviations are

higher. Correlation of stocks return is another factor that contributes to portfolio risk.

Low to negative correlation coefficient reduces overall portfolio risk, whereas high

correlation imposes more risk to the portfolio. The results support that general, developed

markets return movements (USA, UK, Japan) are not correlated or weakly correlated to

emerging markets return (Thailand and Mexico), except Japan that show moderate

correlation to Thailand due to economic and industrial integration. Return movement of

USA and UK are strongly correlated but not to Japan. Moreover return movement of

Thailand is weakly correlated to Mexico but moderately correlated to Japan. It can be

considered that the economic and industrial integration between countries can explain the

influences on countries’ return correlation. The results also show that degree of

correlation is unstable between 1-year and 5-year holding period. In 5-year period

suggest stronger diversification benefit between developed market stocks and emerging

market stocks than 1-year period. In short, the low correlation between emerging market

and developed market suggests diversification opportunities when including emerging

market stocks to a portfolio of developed market stocks and more in 5-year holding

period rather than 1-year holding period.

In order to prove the diversification benefit when including emerging market stocks to a

portfolio of developed market stocks, efficient frontier of developed market stocks,

emerging market stocks and combination of both developed and emerging market stocks

are compared. The result shows the efficient frontier of portfolios of developed market

stocks is in low risk/return region while efficient frontier of portfolio of emerging market

stocks is in high risk/return region and the efficient frontier of portfolios including both

developed and emerging market stocks lie above the previous two frontiers. This make

the portfolios including developed countries alone and emerging markets alone becomes

inefficient because at the same risk level, investors can achieve higher return by changing

their portfolio combination to include both developed and emerging market.

71

Then, the portfolio of sample countries including both developed and emerging countries;

USA, UK, Japan, Thailand and Mexico, is constructed in 1-year and 5-year holding

period. The result shows that the portfolio combination of 1-year and 5-year period are

change and by holding the portfolio for 5 year, return to variability and Sharpe ratio is

improved, while investors accepting higher risk and return. The optimal portfolio

combination that maximize return to variability ratio is constructed of Thailand 6.24%,

USA 69.79%, and Mexico 23.97 % (Return to Variability=0.89) if holding the portfolio

for 1 year, and Thailand 28.93%, USA 69.35%, and Mexico 1.72% (Return to

Variability=1.43) if holding the portfolio for 5 years. In addition, the optimal portfolio

combination that maximize Sharpe Ratio is construct of USA 46.93% and Mexico

53.07% (Sharpe ratio=0.62) for 1-year holding period, in contrast to holding Thailand

27.84%, USA 69.65% and Mexico 2.52% (Sharpe ratio=1.32) for 5-year holding period.

These thesis is yet limited under assumptions of Markowitz’s Mean-Variance Portfolio

Theory, data availability, and data distribution. Future research that can overcome these

assumptions and improve the portfolio efficient frontier, for example, incorporating

transaction cost, actively rebalancing (time the market), including skewness and kurtosis

of data distribution and so forth, will reduce errors and improve of portfolio optimization.

Moreover, familiarity and understanding of different markets will also help in portfolio

selection.

Last but not least, in this thesis, we have examined Thailand as an emerging country and

its stock market. The country has been through the economic crisis, political situations,

and stock market underdevelopment. These issues have direct effects to investor

confidences and the movement of stock returns. Though Thailand stock market has

higher return than those in developed countries, the risk that return fluctuate is

significantly high that overshadow its return level. Therefore, portfolio allocation to Thai

stocks is still only in a small proportion. If Thailand can improve its economic conditions,

political stability, and key stock market development, there is a good indication that

returns will fluctuate less, investors sentiment will regain. Hence, Thailand will become

more interesting investment destination in emerging markets for mutual fund managers.

72

Appendix

Appendix 1

Mutual Fund Investment Objectives, Stock funds

• Aggressive growth funds seek maximum capital growth; current income is not a

significant factor. These funds invest in stocks out of the mainstream, such as new

companies, companies fallen on hard times, or industries temporarily out of favor.

They may use investment techniques involving greater than average risk.

• Growth funds seek capital growth; dividend income is not a significant factor. They

invest in the common stock of well established companies.

• Growth and income funds seek to combine long-term capital growth and current

income. These funds invest in the common stock of companies whose share value has

increased and that have displayed a solid record of paying dividends.

• Precious metals/gold funds seek capital growth. Their portfolios are invested

primarily in securities associated with gold and other precious metals

• International funds seek growth in the value of their investments. Their portfolios are

invested primarily in stocks of companies located outside the United States

• Global equity funds seek growth in the value of their investments. They invest in

stocks traded worldwide. Including those in the United states.

• Income-equity funds seek a high level of income by investing primarily in stocks of

companies with good dividend-paying records.

Source: Haslem, John A. et al. 2003

73

Appendix 2 WORLDWIDE TOTAL NET ASSETS OF MUTUAL FUNDS (millions of US dollars, end of year)

Source: ICI Fact book 2007 Note: Fund of Funds are not included except for France, Luxembourg after 2003 N/A = not available

74

Appendix 3: Retirement Market Assets in US, 2000-2006

Source: ICI Fact Book 2007, 82 Appendix 4: Mutual Funds’ Share of Household Financial Assets in US, 1990-2006

Source: ICI Fact Book 2007

75

Appendix 5:

WORLDWIDE NUMBERS OF MUTUAL FUNDS, 1999-2006

(end of year)

Source: ICI Fact Book 2007

76

Appendix 6:

US Mutual Funds: Estimated Allocation to Emerging Markets, 1996-2003

Source: IMF Working Paper 2004, 21

77

Appendix 7:

Fund Flow vs. Share of Market Capitalization

Source: Kaminsky et. al. 2001, 324

78

Appendix 8: Thailand Key Statistic, 2000-2007 Thailand's Key Economic Indicators

2000 2001 2002 2003 2004 2005 2006 2007 p 1/

1. Population (millions) 61.88 62.31 62.80 63.08 61.97 62.42 62.83 63.04 2. GDP 2.1 GDP at constant 1988 price (billion baht) 3,008.4 3,073.6 3,237.0 3,468.2 3,688.2 3,855.1 4,052.0 4,244.6

(% change) 4.8 2.2 5.3 7.1 6.3 4.5 5.1 4.8 Agriculture (billion baht) ** 309.9 320.0 322.2 363.0 354.4 347.8 361.2 375.1 (% change) 7.2 3.2 0.7 12.7 -2.4 -1.9 3.8 3.9 Non-agriculture (billion baht) ** 2,698.5 2,753.6 2,914.9 3,105.1 3,333.8 3,507.3 3,690.8 3,869.5 (% change) 4.5 2.0 5.9 6.5 7.4 5.2 5.2 4.8 2.2 GDP at current price(billion baht) 4,922.7 5,133.5 5,450.6 5,917.4 6,489.5 7,095.6 7,830.3 8,485.2

(% change) 6.2 4.3 6.2 8.6 9.7 9.3 10.4 8.4 2.3 GNP per capita (baht) 77,863 79,785 83,338 89,144 96,553 104,251 115,098 125,092 3. Inflation 3.1 Headline Consumer Price Index (2002=100) 97.8 99.4 100.0 101.8 104.6 109.3 114.4 117.0

(% change) 1.6 1.6 0.7 1.8 2.7 4.5 4.7 2.3 3.2 Core Consumer Price Index (2002=100) 2/ 98.4 99.6 100.0 100.2 100.6 102.2 104.5 105.6

(% change) 0.7 1.3 0.4 0.2 0.4 1.6 2.3 1.1 4. External Account (billions of US$)

4.1 Export 67.9 63.1 66.1 78.1 94.9 109.2 127.9 151.1 (% change) 19.5 -7.1 4.8 18.2 21.6 15.0 17.2 18.1 4.2 Import 62.4 60.6 63.4 74.3 93.5 117.7 126.9 139.2 (% change) 31.3 -3.0 4.6 17.4 25.7 25.9 7.8 9.6 4.3 Trade balance 5.5 2.5 2.7 3.8 1.5 -8.5 1.0 12.0 4.4 Current account balance 9.3 5.1 4.7 4.8 2.8 -7.9 2.2 14.9 (% of GDP) 7.6 4.4 3.7 3.3 1.7 -4.5 1.1 7.2 4.5 Net capital movement -10.3 -3.5 -1.8 -4.8 3.6 12.6 5.7 -0.9 - Private 3/ -9.8 -2.7 -3.4 -5.5 3.3 11.3 6.2 2.6 - Public -0.3 -0.3 -2.5 -1.9 -2.7 1.3 -0.9 -2.9 - BOT -0.2 -0.4 4.0 2.7 3.1 0.0 0.4 -0.6 4.6 Balance of payments -1.6 1.3 4.2 0.1 5.7 5.4 12.7 3.3 4.7 International reserves (billions of US$) 32.7 33.0 38.9 42.1 49.8 52.1 67.0 87.5

4.8 Swap Obligation (billions of US$) 2.1 2.1 0.5 -5.2 -4.6 -3.8 -6.9 -19.1

4.9 Total debt outstanding (billions of US$) 79.7 67.5 59.5 51.8 51.3 52.0 59.6 61.5

(of which : public debt 4/ ) 33.9 28.3 23.3 16.9 14.9 13.5 13.1 11.6 4.10 Total debt service ratio (%) 15.4 20.8 19.6 16.0 8.5 10.8 11.3 11.1 of which : public (included BOT since 1997) 4.0 8.1 7.9 7.6 1.9 1.1 1.2 0.9

5. Government Finance (fiscal year) (billions of baht)

5.1 Cash balance -116.6 -107.9 -118.7 34.3 17.2 16.9 4.5 -94.2 (as % of GDP) -2.4 -2.1 -2.2 0.6 0.3 0.2 0.1 -1.1 5.2 Total public debt outstanding 5/ 2,180.8 2,315.9 2,601.6 2,508.2 2,691.4 2,778.5 2,892.8 2,948.3 - domestic debt 1,200.0 1,337.2 1,735.5 1,770.2 1,989.9 2,127.3 2,331.2 2,482.9 6. Monetary Statistics 10/ Monetary Statistic according to MFSM 2000

6.1 Narrow Money (billions of baht) 504.4 567.8 656.3 752.8 833.6 898.9 916.2 1,004.0

(% change) -9.5 11.5 15.6 14.7 10.7 7.8 1.9 9.6

79

6.2 Broad Money (billions of baht) 6,056.3 6,404.1 6,488.1 6,885.7 7,281.3 7,736.9 8,218.9 8,317.5 (% change) 3.9 5.7 1.3 6.1 5.7 6.3 6.2 1.2

6.3 Domestic Claims : Included investment (% change) .... .... .... .... 4.2 4.3 0.4 3.0

Claims on Other Nonfinancial Corp,Other Resident Sector & Other financial Corp. (% change)

.... .... .... .... 5.2 5.6 2.4 2.2

6.4 Other Depository Corporations deposits 11/ (% change)

.... .... .... .... 5.3 6.1 7.5 1.0

6.5 Interest rate (year end) 7/

Prime rate 7.50-8.25 7.00-7.50 6.50-7.00 5.50 - 5.75

5.50 - 5.75

6.50-6.75

7.50-8.00

6.85-7.13

Fixed deposits (1 yr.) 3.5 2.75-3.00 2.0 1.0 1.0 2.50-3.50

4.00-5.00

2.25-2.38

7. Exchange rate Baht : US$ (Reference rate) average 8/ 40.2 44.5 43.0 41.5 40.3 40.3 37.93 34.56

Discontinued Series 6.1 M2 (billions of baht) 5,032.7 5,243.6 5,378.9 5,641.8 5,948.4 6,438.9 6,824.0 (% change) 3.7 4.2 2.6 4.9 5.4 8.2 6.0 6.2 M2a (billions of baht) 9/ 5,297.0 5,538.4 5,530.2 5,813.2 6,180.4 6,510.0 6,885.5 (% change) 2.2 4.6 2.4 5.1 6.3 5.3 5.8 6.3 Domestic credit : Included investment (% change) -7.4 -6.1 7.8 1.0 6.3 3.2 1.2

Private (% change) -8.5 -7.5 8.5 3.1 5.9 2.4 0.5 6.4 Deposit 6/ (% change) 5.3 4.0 2.5 4.4 2.6 8.4 5.7 Remark : P = Preliminary

1/.... Not Yet Avaliable. Item 1 is preliminary figures at end - December 2007. Item 3 through 7 are preliminary figures of January - January 2008. Item 4.1 - 4.5 is preliminary figures of January - December 2007. Item 4.7 , 4.8 and 5.1 are the outstanding amount as at end - January 2008. Item 4.9 and 5.2 are the outstanding amount as at end - December 2007. Item 4.10 is debt service ratio of January - December 2007. Item 6 is the outstanding amount as at end - January 2008. 2/ Exclude raw food and energy items from the consumer price index basket. 3/ Include commercial bank and BIBF's . 4/ Include Bank of Thailand's debt. 5/ Exclude Bank of Thailand and Financial Institutions Development Fund's Debt. 6/ Exclude foreign and interbank deposits. 7/ As quoted by the 5 largest banks. 8/ Since July 1997, the figures are represented by average inter-bank exchange rate. 9/ Since January 2002, excluding data on the 56 suspened finance companies. 10/ From 2003, the compilation method follows MFSM 2000. 11/ Excluding inter Other Depository Corporations. **The NESDB has reclassified the GDP by industry to be followed the Thailand Standard Industrial Classification (TSIC) 2001 version since 1995. (Formerly used TSIC 1972 version)

Source: The Bank of Thailand, Data Bank, Economic Data

80

Appendix 9: The World Bank’s Economy Classifications Low-income economies (53) Afghanistan Bangladesh Benin Burkina Faso Burundi Cambodia Central African Republic Chad Comoros Congo, Dem. Rep

Côte d'Ivoire Eritrea Ethiopia Gambia, Ghana Guinea Guinea-Bissau Haiti India Kenya Korea, Dem Rep.

Kyrgyz Republic Lao PDR Liberia Madagascar Malawi Mali Mauritania Mongolia Mozambique Myanmar The Nepal

Niger Nigeria Pakistan Papua New Guinea Rwanda São Tomé and Principe Senegal Sierra Leone Solomon Islands Somalia

Sudan Tajikistan Tanzania Timor-Leste Togo Uganda Uzbekistan Vietnam Yemen, Rep. Zambia Zimbabwe

Lower-middle-income economies (55) Albania Algeria Angola Armenia Azerbaijan Belarus Bhutan Bolivia Bosnia and Herzegovina Cameroon Cape Verde

China Colombia Congo, Rep. Cuba Djibouti Dominican Republic Ecuador Egypt, Arab Rep. El Salvador Fiji Georgia Guatemala

Guyana Honduras Indonesia Iran, Islamic Rep. Iraq Jamaica Jordan Kiribati Lesotho Macedonia, FYR Maldives Marshall Islands

Micronesia, Fed. Sts. Moldova Morocco Namibia Nicaragua Paraguay Peru Philippines Samoa Sri Lanka Suriname Swaziland

Syrian Arab Republic Thailand Tonga Tunisia Turkmenistan Ukraine Vanuatu West Bank and Gaza

Upper-middle-income economies (41) American Samoa Argentina Belize Botswana Brazil Bulgaria Chile Costa Rica Croatia

Dominica Equatorial Guinea Gabon Grenada Hungary Kazakhstan Latvia Lebanon Libya

Lithuania Malaysia Mauritius Mayetta Mexico Montenegro Northern Mariana Islands Oman

Palau Panama Poland Romania Russian Federation Serbia Seychelles Slovak Republic South Africa

St. Kitts and Nevis St. Lucia St. Vincent and the Grenadines Turkey Uruguay Venezuela, RB

High-income economies (60) Andorra Antigua and Barbuda Aruba Australia Austria Bahamas, The Bahrain Barbados Belgium Bermuda Brunei Darussalam Canada Cayman Islands

Channel Islands Cyprus Czech Republic Denmark Estonia Faeroe Islands Finland France French Polynesia Germany Greece Greenland Guam

Hong Kong, China Iceland Ireland Isle of Man Israel Italy Japan Korea, Rep. Kuwait Liechtenstein Luxembourg Macao, China Malta

Monaco Netherlands Netherlands Antilles New Caledonia New Zealand Norway Portugal Puerto Rico Qatar San Marino Saudi Arabia Singapore Slovenia

Spain Sweden Switzerland Trinidad and Tobago United Arab Emirates United Kingdom United States Virgin Islands (U.S.)

Source: The World Bank, Data and Statistic

81

Appendix 10: Data Distribution

a. 1-year holding period

0

4

8

12

16

20

24

-40 -20 0 20 40 60 80

Series : EM

Sample 1988M01 2007M 02

Observations 230

Mean 15.60349

Median 15.36487

Maximum 77.35033

Minimum -51.42325

Std. Dev. 27.77232

Skewness -0.024707

Kurtosis 2.359149

Jarque-Bera 3.959181

Probability 0.138126

0

4

8

12

16

20

24

28

32

-80 -40 0 40 80 120 160

Series : TH AILAND

Sample 1988M01 2007M 02

Observations 230

Mean 11.70360

Median 11.27196

Maximum 169.9925

Minimum -74.40254

Std. Dev. 42.56194

Skewness 0.448432

Kurtosis 3.885643

Jarque-Bera 15.22531

Probability 0.000494

0

5

10

15

20

25

30

35

-40 0 40 80 120 160

Series : M EXIC O

Sample 1988M01 2007M 02

Observations 230

Mean 28.27997

Median 27.64200

Maximum 175.9853

Minimum -63.29663

Std. Dev. 40.19602

Skewness 0.362528

Kurtosis 3.746747

Jarque-Bera 10.38197

Probability 0.005567

82

0

5

10

15

20

25

30

-40 -20 0 20 40 60 80

Series : JAPAN

Sample 1988M01 2007M 02

Observations 230

Mean 2.484645

Median 0.598247

Maximum 82.35157

Minimum -44.09288

Std. Dev. 25.18215

Skewness 0.581093

Kurtosis 2.833318

Jarque-Bera 13.21025

Probability 0.001353

0

5

10

15

20

25

30

-25.0 -12.5 0.0 12.5 25.0 37.5

Series : U K

Sample 1988M01 2007M 02

Observations 230

Mean 8.427561

Median 9.637258

Maximum 46.19592

Minimum -24.61705

Std. Dev. 14.12513

Skewness -0.155169

Kurtosis 2.616720

Jarque-Bera 2.330796

Probability 0.311798

0

5

10

15

20

25

30

-25.0 -12.5 0.0 12.5 25.0 37.5

Series : U SA

Sample 1988M01 2007M 02

Observations 230

Mean 10.63792

Median 10.88478

Maximum 46.53471

Minimum -27.98742

Std. Dev. 15.30406

Skewness -0.466036

Kurtosis 3.156867

Jarque-Bera 8.561403

Probability 0.013833

83

0

4

8

12

16

20

24

28

-25.0 -12.5 0.0 12.5 25.0 37.5

Series : W ORLD

Sample 1988M01 2007M 02

Observations 230

Mean 7.807015

Median 11.03129

Maximum 43.62425

Minimum -29.47138

Std. Dev. 14.17121

Skewness -0.675532

Kurtosis 3.046608

Jarque-Bera 17.51398

Probability 0.000157

b. 5-Year holding period

0

10

20

30

40

0 100 200 300

Series : EM

Sample 1992M01 2007M 02

Observations 182

Mean 72.00670

Median 48.18177

Maximum 370.7304

Minimum -48.10591

Std. Dev. 99.66672

Skewness 0.777096

Kurtosis 2.810647

Jarque-Bera 18.58956

Probability 0.000092

0

10

20

30

40

50

-100 0 100 200 300

Series : T H AILAND

Sample 1992M01 2007M 02

Observations 182

Mean 50.73300

Median 54.25342

Maximum 341.1976

Minimum -88.73953

Std. Dev. 114.7019

Skewness 0.276554

Kurtosis 1.831548

Jarque-Bera 12.67333

Probability 0.001770

84

0

10

20

30

40

50

60

0 200 400 600 800 1000 1200

Series : M EXIC O

Sample 1992M01 2007M 02

Observations 182

Mean 169.0967

Median 69.56820

Maximum 1243.670

Minimum -50.38571

Std. Dev. 263.8594

Skewness 2.176464

Kurtosis 7.114622

Jarque-Bera 272.0755

Probability 0.000000

0

5

10

15

20

25

30

-40 -20 0 20 40 60 80 100

Series : JAPAN

Sample 1992M01 2007M 02

Observations 182

Mean -0.976555

Median -8.209256

Maximum 106.2962

Minimum -46.81529

Std. Dev. 34.09806

Skewness 1.293761

Kurtosis 4.186976

Jarque-Bera 61.45668

Probability 0.000000

0

4

8

12

16

20

24

-25 0 25 50 75 100 125

Series : U K

Sample 1992M01 2007M 02

Observations 182

Mean 41.68472

Median 37.34834

Maximum 130.4254

Minimum -42.11200

Std. Dev. 43.09385

Skewness 0.107233

Kurtosis 2.208960

Jarque-Bera 5.094032

Probability 0.078315

85

0

5

10

15

20

25

0 40 80 120 160 200 240

Series : U SA

Sample 1992M01 2007M 02

Observations 182

Mean 66.94064

Median 63.91725

Maximum 233.1333

Minimum -25.22319

Std. Dev. 67.86615

Skewness 0.544246

Kurtosis 2.462054

Jarque-Bera 11.17934

Probability 0.003736

86

Appendix 11:

Note: A portfolio of sample developed markets (USA, UK and Japan), a portfolio of emerging markets (Thailand and Mexico), and a portfolio combination of both developed market and emerging markets (USA, UK, Japan, Thailand, Mexico) are constructed for both 1-year and 5-year holding period. The result shows that the efficient frontier of a portfolio combination of developed and emerging markets lie above the efficient frontier developed markets portfolio and emerging markets portfolio in both periods. It suggests that by investing in a portfolio that includes both developed and emerging market, investors receive more return for the same risk level as investing in a portfolio of developed markets only and emerging market only.

87

References

Ait-Sahalia, Y. and Brandt, M.W., 2001: “Variable Selection for Portfolio Choice”, The

Journal of Finance, 4 (August), 1297-1351.

Azeez, A. A. and Yonezawa, Y., 2005: “Macroeconomic factors and the empirical

content of the Arbitrage Pricing Theory in the Japanese stock market”, Japan and

the World Economy 18, 568-591.

Bartram, S. M. and Dufey, G., 2001: “International Portfolio Investment: Theory,

Evidence, and Institutional Franework”, Financial Markets,

Institutions&Instruments, 10, (august), Blackwell, 85-155.

Bodie, Z., Kane, A. and Marcus, A. J., 1993: Investments, McGraw-Hill/Irwin, 2004

Brands, S. and Gallagher, D.R., 2005: “Portfolio Selection, diversification and fund-of-

funds: a note”, Accounting and Finance 45, Blackwell, 185-197.

Brentani, C., 2001: Portfolio Management in Practice: Essential Capital Markets,

Elsevier Butterworth-Heinemann.

Brocato, J. and Steed, S., 1998: “Optimal Asset Allocation Over the Business Cycle”,

The Financial Review, 33/3, (August), 129-148.

Butler, K.C., Domain, D.L., and Simonds, R.R., 1995: “International Portfolio

Diversification and the Magnitude of the Market Timer’s Penalty”, Journal of

International Financial Management and Accounting. 6/3 (December), 193-204

Driessen, J. and Laeven L., 2006: “International Portfolio Diversification Benefits: Cross-

country evidence from a local perspective”, Journal of Banking and Finance 31,

1693-1712.

Durham, J. B., 2000: “Emerging Stock Market Liberalisation, Total Returns, and Real

Effects: Some Sensitivity Analysis”, QEH working Paper no. 51(October),

Finance and Trade Policy Research Center, 1-54.

Emerging Stock Markets Factbook 1997, International Finance Corporation.

Fletcher, J. and Marshall, A., 2005: “An Empirical Examination of the Benefits of

International Diversification”

88

Forbes, K. J. and Rigobon, R., 2002: “No Contagion, Only Interdependence: Measuring

Stock Market Comovements”, The Journal of Finance 57/5 (October), 2223-

2261.

Georgios E Chortareas, John B McDermott, and Titos E Ritsatos, 2000: “Stock Market

Volatility in an Emerging Market: Further Evidence from the Athens Stock

Exchange”, Journal of Business Finance & Accounting 27 (7&8), 983–1002.

Goetzmann, W. N., Li, L. and Rouwenhorst, K. Geert, 2002: “Long-Term Global Market

Correlations”, Yale ICF Working Paper, No. 00-06 (February).

Global Develop Finance 2007, the Globalization of Corporate Finance in Developing

Countries, The world Bank.

Grabel, Ilene, 1999: “Emerging Stock Markets and Third World Development: The Post-

Keynesian Case for Pressimism”, Foundations of International Economics,

London, Routledge.

Grubel, H., 1968: “Internationally diversified portfolios: welfare gains and capital flows”

American Economic Review 58, 1299–1314.

Haslem, John A., 2003; Mutual Funds: Risk and Performance Analysis for Decision

Making, Black well.

Islam, S. M. N. and Watanapalachikul, S., 2005: Empirical Finance: Modeling and

Analysis of Emerging Financial and Stock Markets, Physica-Verlag Heidelberg,

New York.

Jackson, K. D., 1999: “The Asian Contagion, The Causes and Consequences of a

Financial Crisis”, Westview Press (January).

Jensen, Gerald R. and Mercer, Jeffrey M., 2003: “New Evidence on Optimal Asset

Allocation”, The Financial Review, 38/3, (August), 435-454.

Kaminsky, G. L., Lyons, R. K., and Schmukler, S. L., 2001: “ Mutual Fund Investment in

Emerging Markets: An Overview”, The World Bank Economic Review 14(2):

315-340.

Kritzman, Mark:1994, “What practitioners need to know about time diversification”,

Financial Analysts Journal. January-February: 14-18.

89

Larsen, Glen A. and Resnick, Bruce G., 2000: “The Optimal Construction of

Internationally Diversified Equity Portfolios Hedged Against Exchange Rate

Uncertainty”, European Financial Management, Vol. 6/4, 479-514.

Levy, H., 1972: “Portfolio Performance and Investment Horizon”, Journal of

Management Science 18/12 (August), 645-653.

Liaw, K. T.,2004: Cappital Market, Thomson, Sourth-Western.

Levich, R. M., 2001: “The importance of Emerging Capital Market”, Brookings-Waraton

Papers on Financial Serivices, 4th Annual Conference on Integrating the

Emerging Market Countries into the Global Financial System, (January).

Levine, R., 2001: “International Financial Liberalization and Economic Growth”, Review

of International Economics 9 (4), 688–702.

McCoulloch, B., 2003: “Geometric Return and Portfolio Analysis”, Treasury Working

Paper (December).

Markowitz, H. M., 1991: Portfolio Selection: Efficient Diversification of Investments,

Second edition, Blackwell.

Masuyama, S., 1999: East Asia’s Financial Systems: Evolution and Crisis, Manura

Research Institute, Tokyo and Institute of Stougheast Asian Studies, Singapore.

McDonald, J.G. and Osborne, A.E., 1974: “Forecasting the Market Return on Common

Stock”, Journal of Business Finance and Accounting, 1/2 (June), 217-237.

Mishkin, F. S. and Eakins, S. G., 2006: Financial Markets and Institutions, Pearson, New

York.

Naranjo, A. and Porter, B., 2007: “Including Emerging Markets in International

Momentum Investment Strategies”, Emerging Market Review 8, 147-166.

Ong, Li Lian and Sy, A., 2004: “The Rold of Mature Market Mutual Funds in Emerging

Markets: Myth or Mayhem?”, IMF Working Paper (july).

Price, Magaret M., 1994: Emerging Stock Market, McGraw-Hill.

Ryan, L., 2000, “The Asian Economic Unmasked: The Political Economy of the

Reality”, International Journal of Social Economics, 27.

Siamwalla, A., 2000: “Anatomy of the Thai Economic Crisis”, Thailand Development

Research Institution (TDRI), May.

90

Strong, N. and Taylor, N., 2001: “Time Diversification: Empirical Tests”, Journal of

Business Finance and Accounting, 28, (April/May), Blackwell, 263-302

Vichyanond, P., 2000: “Capital Market Development in Thailand”, Thailand

Development Research Institution (March)

Warr, P., 1999: What Happened to Thailand?, Blackwell Publishers, 631-650.

Wright, D. J., Reilly, F. K., and Chan, K. C., 2000: “Bond Market Volatility Compared to

Stock Market Volatility”, The Journal of Portfolio Management (Fall).

Websites

Bank of Thailand: www.bot.or.th

Emerging Portfolio Fund Research: www.emergingportfolio.com

International Financial Corporation: www.ifc.org

Investment Company Institution www.ici.org

Morgan Stanley Capital International Inc.: www.msci.com

World Federation of Exchange: www.world-exchanges.com

The Morningstar: www.morningstar.com

The Stock Exchange of Thailand: www.set.or.th

The World Bank: www.worldbank.org