Presentation on theme: "1 Short-selling and the problem of market maturity in Latin America Miguel Díaz-Martínez and Emmanuel Fragnière."— Presentation transcript:
1 Short-selling and the problem of market maturity in Latin America Miguel Díaz-Martínez and Emmanuel Fragnière
2 Reading Questions 1. Is portfolio theory and optimization techniques equally relevant when evaluating the integration of short positions in asset allocation strategies in Latin American stock markets as they are in developed economies? 2. If not, is it possible to adjust such techniques by adding variables related to specific-country imperfections to make them applicable in Latin America? 3. What are the main issues that we should consider when considering short sales in Latin America? 4. What conclusions can be drawn from a comparative analysis of short sales in Latin American countries?
3 Context Latin American countries have particular structural features that complicate the regulatory environment of capital markets and affect the effective execution of short sales. Specifically, Latin American capital markets are characterized by: Reduced liquidity Limited price formation Unavailability of information Small economic size Factors affecting country risk perception from the international investor perspective All this makes it difficult to assess the appropriateness of short sales norms
Review of national regulatory regimes Brazil: Naked short selling is not allowed. Punitive rules that inhibit the non-delivery of stocks at settlement (T+3). Some authors argue that The rules in place have limited leveraged speculation therefore avoiding the expansion of the crisis. Peru: Short selling can only be made with the shares listed at the Tabla de Valores Referenciales 1 and 2, two lists that include the most liquid securities traded on the Lima Stock Exchange. There are also price restrictions through the uptick rule. Mexico: Short selling is allowed but there is an uptick rule. The Secondary Legislation (Circular Única) establishes that short selling is only allowed through a Stock Exchange, and for only highly liquid and semi-liquid stocks. Chile: The government has issued a manual that contemplates the mechanics, conditions and restrictions of short selling operations; and stock brokers have developed standard formats to engage customers in short sales. However, short selling in the stock market is not very developed and it is limited to a small number of stocks. Naked short selling is not allowed. Argentina: With some specific restrictions subject to the companies or securities traded, non-naked short selling is allowed
Previous studies about short selling in Latin America Literature is very limited and essentially derived from from analysis conducted for the entire set of emerging countries Bris et al. (2007): Studied 46 countries, and found evidence that prices incorporate negative information faster in countries where short sales are allowed and practiced. Charownrook and Daouk (2009): Created a short-selling feasibility indicator to analyze stock market indices around the world. Their findings suggest that aggregate returns and liquidity are better when short-selling is possible
Previous studies about short selling in Latin America There is also a range of studies evaluating specific aspects in individual countries and governmental studies assessing short- selling policies. Among these: Torres et al. (2004): sustain that portfolio building methods are based on hypothesis that are not real in emerging markets Agudelo et al. (2010): have undertaken a comparative analysis of the Chilean and North American markets and concluded that, where legal frameworks do not allow them, short sales can be implemented through a temporary stock transfer contract Likewise, there is a range of government publications and newspaper articles, but these are not theoretically conclusive
Previous studies on short selling in Latin America Due to the inconclusiveness of short selling articles and the lack of research, it is worth analyzing more general studies of financial markets and economic assessments from academicians and monetary authorities, such as: Feldstein (1999): examined the actions of speculators and the macroeconomic events during the global financial crisis The Bank of International Settlements (BIS, 2002) published a series of papers about the development of bond markets Regarding equity markets there are various studies that give an insight of stock market capitalization and emerging countries efficiency (e.g. Bekaert and Harvey (2000))
Short selling in Latin America As explained earlier, Latin American markets are structurally different making short selling more limited To look beyond such limitations, we analyzed the relationship between global capital flows and a wide range of financial instruments traded in emerging countries Our findings suggest that market liquidity and economic size are the fundamental aspects allowing the development of short sales This allowed us to identify the characteristics of short sales at three levels: Currency markets – these are normally big and very liquid Debt markets – these are relatively big and liquid Equity markets – these are normally not as liquid as currency and debt markets
Short selling in Latin American Currency Markets The possibility of short sell depends on the existence of a fixed or a floating exchange rate regime If the currency floats freely, investors can borrow local currency, sell it for foreign currency, and then invest the foreign currency; they then expect to sell their foreign currency after the local currency's fall and repay the original debt with cheaper currency The elements usually considered by investors to evaluate short sales against an emerging countrys currency are: The countrys current account deficit Aggregated balance sheet imbalances in the banking sector Banking implosions, and their consequent contagion turbulence These elements provide an indication of the expected devaluation.
Short selling in Latin American Debt Markets The possibility of short sell depends on the existence of secondary markets, and repo and funding markets If a speculator wants to short sell, he may sell a bond in secondary markets, receive the money from the sale, and then lend this money and receive a bond as payment guarantee. The bond received as guarantee is transferred to the buyer. At the maturity date of the lending the speculator will receive back the money lent and use it to buy another bond with exactly the same characteristics of the one he sold. This bond is given to the money borrower (i.e. the original bond holder) In Latin America and Eastern Europe, debt markets are relatively liquid and deep in Brazil, Chile, Czech Republic, Poland, Mexico, Colombia, Peru and Hungary
Short selling in Latin American Equity Markets Even though countries have developed regulations on the topic, this table shows that short selling in equity markets is not feasible in the great majority of countries analyzed In the analysis of debt and currency markets, we found that short selling is very feasible, and investors often elaborate selling mechanisms in the absence of regulation Also, a statistical analysis of stock market indexes shows low correlations which is partly explained by the hazardous political environment and lack of development in Latin America Therefore, we hypothesize that the development of short sales is a determined by the maturity of markets Regulation should come as a way to regulate trading activities were markets are mature
Discussion and Conclusions Global capital flows are one of the main drivers determining the depth of Latin American capital markets Market liquidity allows investors to balance risk and return, which is essential for the integration of short sales in portfolios strategies The evaluation of short selling policies is complicated in Latin America where markets are inefficient The comparison between developed and Latin American markets allows to bring interesting hypotheses: In developed countries, it is possible to evaluate correlations of stock prices, build efficient portfolios and compare their returns to risk free returns In Latin America, correlations are strongly biased depending on political and economic events Therefore, in less Latin American economies sovereign risk becomes the most evident variable to evaluate against return
Further thoughts It would be worth studying global portfolio strategies involving several securities within different Latin American markets to help increasing the understanding of this topic It is worth noting the lack of public statistics to provide any reasonable quantification of short selling in Latin America We believe that theory about short sales in Latin America is not complete. This short article intended to contribute to the creation of theoretical grounds in this topic