Frontier Market Risks - dummies

By Gavin Graham, Al Emid

Part of Frontier Markets For Dummies Cheat Sheet

Frontier market investments do have risks. It is often recommended that these markets comprise between 5 and 10 percent of your total international equity holdings as a baseline weighting.

There are four main types of risk baked into many types of investments, including those based in frontier markets: investment risk, political and social risk, currency risk, and liquidity risk.

Investment risk

Investment risk refers to the hazards specifically connected to the shares of a specific company:

  • The quality of management

  • The company’s preeminence (or lack of it) in its product sector

  • The effect of the company’s debt load

  • The company’s relationships with its stakeholders such as unions and customers

  • The presence or absence of barriers to the entry of competitors

  • The company’s ability to keep a healthy pipeline of products being readied to come to market

  • The company’s risk management capabilities

Political and social risk

Political and social risk refers to factors that are not directly connected to the company but are sufficiently strong in the surrounding environment to have an impact on its fortunes. These include the following:

  • The rule of law. Knowing that the rules that govern how your investment is treated will be followed and that contracts signed by the company in which you’ve bought shares will be honored is one of the most important factors to consider when investing in a country or region. It’s noticeable that the majority of the Frontier Markets considered attractive usually have common law systems like the United Kingdom and the United States.

  • The country’s stability. Formerly unstable African nations are now considered much more stable then decades earlier.

  • The presence or absence of militant groups. If we use the Middle East as an example, at the time of writing, Egypt, Syria, Lebanon, and Libya were embroiled in political crises but the United Arab Emirates, Qatar, and several other nations in the region are stable investment destinations.

  • The proximity to countries in crisis. At the time of writing, Turkey was relatively stable politically and socially but its economy appeared threatened by the influx of refugees from Syria.

  • The presence or absence of corruption in senior levels of government.

Currency risk

Currency risk refers to the potential for costs when transactions involve more than one currency. These risks can occur in several ways:

  • Through the company’s own transactions

  • Through whether it retains revenues in a foreign market or repatriates them to its home market such as the United States

  • Through charges levied by financial institutions involved in the transactions

  • Through the exposure of a country’s currency to speculation

Liquidity risk

Liquidity risk refers to the ease or difficulty, speed, and complexity involved in transactions. Most Frontier and some Emerging markets are still relatively illiquid, meaning that it is difficult to buy large amounts of equities quickly and almost impossible to sell them quickly. One of the major issues for investors in these markets is the settlement of trades on the stock market. Many countries lack a central electronic market, and trades have to be settled by the movement of physical stock certificates between parties to the transaction.

Then there are issues with finding suitable custodian banks to hold the shares in the company once they have been bought. Usually it is not practical for investors to begin trading in these markets until a major international bank such as Citigroup or HSBC provides a custodian service, which guarantees that an investor actually has ownership of shares that they have purchased.