The diversification potential offered by emerging markets in portfolio management

Abstract

This dissertation provides empirical evidence on diversification potential offered by emerging markets when compared to developed markets. It also, provides the risk and return behaviour depicted from two asset portfolios incorporating both developed markets and emerging markets. The data set includes daily data on trading volumes of eight indices whereby four represent developed countries and four represent emerging countries. The sample period is ten years from 1st January 1998 to 31st December 2007. A simple linear regression model between the developed and emerging market indices is conducted. It was found that a positive relationship exists between developed market indices and emerging market indices except for China. This can be reaffirmed by the results obtained from the correlation matrix. When comparing the first five years of the data set with the second five years of the data set, positive relationship between developed and emerging markets increased with the exception of Russia. By means of the minimum variance portfolio model, the expected return and standard deviation of two asset portfolios incorporating both developed and emerging markets are determined. From such analysis, it was found that emerging countries are characterized by higher risks and higher returns whereas developed countries are associated with lower risks and lower returns, when comparing them together. When analysing the results of the correlation coefficients together with the results obtained from the minimum variance portfolios, it was found that China has the lowest correlation. With regards to the other portfolios, there is a mixture of results. This dissertation shows that as time goes by, emerging markets are moving in the same direction as developed markets since a positive relationship is dominant. However, I conclude that room for diversification potential is still present between developed and emerging markets.