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I am grateful to Jorge Roldos for useful comments and suggestions.
This paper is related to earlier joint work with Chakravorti and Lall (2003) in terms of the broad topic, but differs in terms of its focus and modeling framework.
Emerging debt market (EDM) is the market for the dollar- or euro-denominated eurobonds issued by the emerging market sovereigns and corporates.
The term “dedicated emerging market investor” typically refers to an asset manager that has a mandate to invest exclusively in emerging market securities. Such an investor is usually benchmarked against an emerging market index (i.e., his performance is measured relative to the performance of a particular benchmark portfolio). The term “crossover investor” typically refers to an asset manager who does not have an EM specific mandate, but can invest in the EM securities that are part of the asset class which is specified in his investment mandate (equity or fixed income). Such an investor may or may not be benchmarked against an index that includes EM assets (for instance, for the U.S. High-Grade or U.S. High-Yield bond fund manager, the EM dollar-denominated bond exposure represents an “out-of-index” bet; such investors would typically cross-over into EMs to pick up yield).
Schinasi and Smith (2000) argue that this is the most interesting and relevant case because asset returns are generally positively correlated across countries.
It is not clear, however, whether VaR rules are “worse” than other types of constraints in terms of exacerbating asset price volatility. In the partial equilibrium framework, VaR rules do not seem to produce portfolio rebalancing dynamics that are very different from a variety of other portfolio management rules (see Schinasi and Smith 2000).
The emerging market assets A and B can also be viewed as portfolios of assets, for example, A could be a portfolio of the Latin American equities and B could be a portfolio of Asian equities.
There is an extensive literature on delegated portfolio management that analyses the ways in which the incentives of fund managers can be aligned with the preferences of end investors under different assumptions about risk-aversion and information asymmetries. The detailed discussion of these issues is beyond the scope of this paper and in what follows, the analysis will focus on rules and restrictions that are standard in finance literature. Also, in what follows, no distinction will be made between “investors” and “fund managers.”
In the U.S. mutual fund industry, the decision by the U.S. Congress to repeal the short-sale restriction for mutual funds in 1997 and the Securities and Exchange Commision (SEC) decision to expand the allowable securities list for mutual funds led to the appearance of the first long-short mutual funds in 1998. Some of these “next generation” mutual funds are also reportedly using limited leverage and limited incentive fees, and are commonly referred to as “hedged mutual funds” (HMFs). According to industry experts, assets under the management of HMFs grew from $2.4 billion in 1998 to about $6 billion in 2002, which is still a very small fraction of the U.S. mutual fund industry assets (around $4 trillion, as of end-2002).
For dollar denominated emerging market sovereign bonds, the typical benchmark indices are JP Morgan’s Emerging Market Bond Index Plus (EMBI+) and EMBI Global indices. For emerging market equities, the most commonly used benchmark index is Morgan Stanley Capital International (MSCI) Emerging Markets Free index.
According to the IOSCO report (2004), “passive management encompasses benchmark funds, which follow some indices with a very tight tracking error.”
This may not be the case for all types of shocks. For instance, Schinasi and Smith (2000) analyze portfolio re-allocation decisions by leveraged risk-averse investors in response to “capital events” (capital loss), in which case they choose to scale back their risky asset exposures.
Note that k > RM, by assumption.