Risk and Return in the Next Frontier

Abstract

This article investigates the risk-return relations of stocks traded in frontier markets, a class of small, illiquid, less accessible and less known emerging markets that has escaped the attention of many researchers. We examine the cross-section of risk premiums of 360 stocks traded in 19 frontier markets for the period from January 1997 to June 2004. We first observe that frontier markets provide greater return potentials than emerging and developed markets as well as further diversification benefits. Our investigation indicates that the risks involved when investing in frontier markets can be better understood by using a multifactor extension of CAPM which consists of fundamental factors like beta, price to book and size, and country specific factors including political, economic and financial risk ratings. Two surprising findings emerge from this study: (1) small and value stocks are less risky investment avenues than large and growth stocks, and (2) political, economic and financial risk factors have the greatest impact on risk premiums. Global investors should pay greater attention to institutional reforms in frontier economies leading to a more decentralised political system, improved national governance and a more transparent institutional and legal framework.

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