Latin American Financial Markets: Developments in Financial Innovations: Volume 5

This book is an attempt to reflect on what we have learned from financial policies and financial crises in Latin America. The 21 chapters in this volume capture the developments in various ways. They cover theoretical contributions, regional empirical studies, and specific inquiries on Argentina, Brazil, Chile, Colombia, Cuba, Ecuador, Mexico, Peru and Venezuela. The breadth of methodologies implemented suggests that researchers are looking at Latin American financial markets through a variety of lenses. The chapters are divided into 7 parts, including, in Part I, an initial overview. Part II examines the foreign exchange markets in Latin America and their interactions with other markets. Part III discusses dollarization issues in the region. Part IV then takes up the issue of banking in Latin America. Equity and bond markets are considered in Parts V and VI, respectively. Lastly, Part VII considers pension systems in Latin America. Taken as a whole, the 21 chapters seize the excitement of studying Latin America and provide lessons that are applicable around the world.

The purpose of this study is to investigate the relationship between the flow of funds and growth variables for Latin America during the period of 1973–2000. To do so, we present a four equation econometric model that represents the traditional Monetarist and Keynesian perspectives. We also examine the hypothesis that the region can grow through gains from trade, through investigating trade as a source of growth from both computational general equilibrium (CGE) and Cournot-Nash equilibrium standpoints. Analyzing several scenarios, we determine that liberalization and reduced protectionism are superior strategies for Latin America.

This paper analyzes two views on the issue of FDI and stock market development. The first view is that FDI is negatively correlated with the development of stock markets. The second view is that FDI is positively related to stock market development. After addressing the issues that might lead to these conclusions, the hypothesis is tested that the level of stock market development in a country is positively correlated to FDI. Data is collected from four Latin American countries and an empirical model is proposed to explain the observed relationship. Additional explanatory variables were included, and a model is developed.

Latin American financial executives are emerging as strategic planners. In this chapter some linkages between strategy and finance in the case of Latin American corporations are shown to guide decision-makers in gaining insights when applying recognized methods of capital budgeting. Results of a survey of corporate executives shed light on the criteria used in corporations of the region to evaluate investment projects, make capital budgeting decisions, consider adjustments needed, and make an appraisal of the overall interaction of factors related to strategic capital budgeting.

In September 1999, the Central Bank of Chile eliminated the floating band for the nominal exchange rate, which operated since 1984, and established a free float. This lasted until the burst of the last Argentinean economic crisis in July 2001. Since then, the Central Bank has smoothed out the exchange rate path by selling U.S. dollars and/or issuing U.S. dollar-denominated bonds. We examine the free float period by assessing whether the increase in exchange rate volatility was as sharp as expected. We show that volatility went up, but only slightly.

In 1995 the Chicago Mercantile Exchange (CME) introduced a Brazilian Real futures contract. This study explores whether the level of futures contract hedging activity has affected the volatility in Brazil’s equity market. As a proxy for volatility, a threshold autoregressive conditional heteroskedasticity (TARCH) model is employed to obtain the conditional variance of the log-daily returns in the BOVESPA, the Brazilian stock market index. Impulse response functions from a vector autoregressive (VAR) model are utilized to analyze the relationship between volatility and futures trading activity. The empirical results indicate that increased hedging activity has increased return volatility in Brazil’s equity markets.

The Cuban dollarization is an original, complex phenomenon. In spite of serious difficulties, till now the process has remained under control. The government has reached in some degree its goal of rising foreign currency inflows, thus also of insuring economic recovery. Obviously, the dollarization’s effects have not been all positive, and the state recurrently recalls its wish to suppress it as soon as possible. This article explains to what extent the present dollarization is to be distinguished from the pre-revolutionary one; analyses its causes, mechanisms, and effects; and evaluates the debate about dollarization and scenarios of de-dollarization for Cuba.

Propensity to dollarize in Latin America in the demand-side of some economies of the region has a strong political risk component which, in the past, was mainly carried out by inflationary pressures. Coping with risk meant holding FCDs. A recursive multilevel model is developed and empirically tested with Colombia’s data to stress a country-specific tendency to dollarize due to political risk. The chapter’s conclusions suggest that consideration of issues, policies and implications inherent to the decision to dollarize cannot ignore that, the solution to any government-enforced dilemma in the supply-side of these economies, is also politically motivated. Results of a survey are also provided.

This paper extends a recent study on financial dollarization of Broda and Levy Yeyati (2003) by introducing a lending of last resort intervention contingent both on banks’ portfolio currency composition and on banks’ monitoring effort. We show that when the lender of last resort commitment to intervene is matched with some operational discretion, according to a “constructive ambiguity” approach, then the provision of emergency liquidity may be crucial to enable distressed, but well-behaved banks, to survive and finance “high quality” investment projects.

Significant structural changes of the Mexican banking industry have resulted in greater concentration: first, the 1982 expropriation and government control; later on, in 1990, the decision to re-privatize it. In addition, when the economy turned around in 1994–1995, the financial health of several banks rapidly deteriorated and ended in one of the most critical financial crisis the country has experienced. Among the bold measures taken to rescue the system, the banking industry was fully open to foreign investment. At the time of this writing, more than 80% of the banking industry in Mexico is controlled by foreign world class banks.

This chapter develops a Probit model that identifies the financial variables explaining the bankruptcy of banking institutions in Ecuador as a function of efficiency, assets, capital, risk and operating income. The implications of this study verify the validity of the solvency theory over the self-fulfilled panic speculations. The criteria used was a high Pseudo R2 and an as high as possible Efficiency Index. The model yielded a Pseudo R2 of 89.14% and an Efficiency Index of 96.7%. The model is useful in preventing bankruptcy of a bank one year in advance.

This paper studies banking crises in a framework where the government can be biased in favor of a “business elite.” When the deposit contract is such that the run on the bank takes place only if the economic system is in a recession, the presence of a “crony” government introduces an element of indeterminacy, i.e. equilibrium can be multiple. Moreover, by means of an information updating mechanism, it is shown that the crisis may spread out to countries “similar” to the one that is examined, i.e. that contagion is possible.

Deviations from efficiency widely documented for the case of developed capital markets include the presence of seasonal patterns. These anomalies, fairly well known by investors, could possibly lead to obtaining extraordinary gains. Although markets from the developing and transitional economies have grown significantly during the last decades, research concerning their seasonal behavior is limited. This paper examines the day-of-the week and month-of-the year effect for the seven Latin American stock exchanges: Argentina, Brazil, Chile, Colombia, Mexico, Peru, and Venezuela. Returns derived from the local nominal indexes, adjusted for inflation indexes, and dollar adjusted indexes are analyzed to identify the behavior of each exchange and draw some comparisons.

Extant research posits that host country investors value geographical proximity and familiarity. American investors are likely to be more familiar with business, legal and economic conditions of Latin America compared to distant emerging market countries. Furthermore, the trading time of Latin American stock markets overlap significantly with that of U.S. markets. Therefore, we expect Latin American ADRs to enjoy better liquidity than ADRs from other emerging markets. Consistent with our expectations, we find weak evidence that ADRs from Latin America have lower effective spreads and adverse selection component of spreads compared to ADRs from other emerging markets.

In this paper we investigate the empirical performance of an alternative beta risk estimator, which is designed to be superior to its conventional counterparts in situations of extreme thin trading. The estimator used is based on the sample selectivity model. The study compares the resultant selectivity-corrected beta to the OLS beta and Dimson Betas. We demonstrate the empirical behaviour of the selectivity corrected beta estimator using a sample of stocks in seven countries from Latin America. The results indicate that the selectivity-corrected beta does correct the downward bias of the OLS estimates and is likely to better estimate stock risk.

This paper examines stock prices reaction to open market repurchases announcements at the São Paulo Stock Exchange between May 30, 1997 and October 31, 1998. This institutional scenario is a good testing ground for some theoretical hypotheses about stock repurchases announcements, because during this period there were taxes on capital gains but not on dividends. Using an event study methodology, we examined 110 episodes and found very small abnormal returns. Those results can not be explained by two main competing theoretical explanations. The Cumulative Abnormal Returns pattern found clearly suggests that repurchase announcements affected the behavior of stock prices in ways not described in previous studies.

This study examines transmission of U.S. equity markets returns and volatility into Brazilian equity and labor markets. Monthly closing prices of U.S. S&P500 and Bovespa indexes are used to proxy U.S. and Brazilian equity market returns. Brazilian monthly unemployment rates and the average wage index are used to measure U.S. equity market spillovers on foreign labor markets. Using a vector autoregression (VAR) model, a unidirectional return and volatility transmission from the U.S. to Brazil is found. The evidence also indicates that there is a weaker but significant lagged spillover of U.S. stock returns and volatility to the Brazilian labor market.

From the early 1980s until the late 1990s the term structure of interest rates in Chile was usually downward sloping, particularly for long maturities. We postulate that the explanation is behind liquidity premium of the term structure of interest rates. Based upon a parsimonious theoretical model, we show that the sign of liquidity premium depends on both expected return and risk.

For our sample period 1983–1999, investors were willing to hold long-term assets even though their return was relatively lower. This appears to be a consequence of indexation, which reduced risk of long-term bonds as their return was linked to past inflation.

Corporate bonds have been a major source of medium and long-term financing in Brazil. We analyze how corporate bond covenants have been used to mitigate agency costs between shareholders and bondholders. Our data includes 119 corporate bond indentures issued in Brazil from 1998 to 2001. This paper analyzes whether public investors have demanded stricter terms in corporate bond indentures. When comparing to previous studies of Anderson (1999) and of Filgueira and Leal (2001), we found empirical evidence that: (a) more bond issues with no indexed inflation features, but more floating rate interest features to match market needs; (b) no major changes for contingent maturity features; (c) loose covenants with respect to dividend and financing actions; and (d) tighter covenants regarding change in control and/or ownership and negative pledge. There is empirical evidence that the role of sponsor may partially mitigate risks borne by bondholders.

Social pension and security systems worldwide are experiencing difficulties in maintaining the financing required to provide promised benefits. Despite their economic and political difficulties, many Latin American countries have arguably been more proactive and innovative with the implementation of social security reform than other regions of the world. Suggestions for reform of the Social Security system in Venezuela are provided by integrating many of the same concepts found in other restructurings in Latin America. It is the conclusion of this analysis that, given the political and economic instability of the region, a major overhaul of the existing system is not politically feasible. An incremental approach with minimal disruption is more attainable given the circumstances.

The paper uses 101 years of Chilean and international financial assets returns to investigate mean-variance optimal portfolio allocations. The key conclusion is that the share of international unhedged investments is substantial even in minimum risk portfolios (20%), unless the period 1980–2002 is assumed to be drawn from a different distribution and previous history is disregarded. In addition to that, the paper finds that mean-variance optimal investors would have generated substantial demand for an asset replicating the return profile of an efficient pay-as-you-go pension scheme. Labour income and departures from log-normality of returns might, however, affect the latter conclusion.