The potential in emerging markets has sparked renewed interest among investors, and the interest has risen for two reasons: first, the speculative excess that permeates these areas of the world; and, second, expectations that the so-called “green shoots” will lead to global economic growth in 2010.

Historically, the ebb and flow of emerging markets is driven by boom-and-bust scenarios, which themselves are driven by mutual fund cash inflows and outflows. Since the beginning of the year, more than US$35 billion has flowed into the emerging markets, with the bulk going into China.

Speculative excess is never helpful — especially in China, where monetary authorities have become among the most accommodating in the world as part of the government’s effort to revive the country’s flagging, export-driven economy.

The same authorities have also been encouraging banks to lend money. And it is working: Chinese banks are lending money with the same enthusiasm as U.S. banks did during the peak of the U.S. real estate boom earlier this decade.

As a result of China’s massive stimulus program, rising prices for Chinese real estate are supporting asset values that, in theory, back higher loan values. One could argue that by creating its own version of U.S.-style speculative excess, China is in a game of one-upmanship with the world’s largest economy.

But China is not necessarily shielded from the downside risks that this game entails. Recently, there have been rumours that those same authorities are poised to tighten monetary policy. In what looks like a classic example of history repeating itself, we may be in the early stages of a Chinese asset bubble about to burst.

Add to that a Chinese stock market that, by all accounts, looks frothy. Initial public offerings are jumping out of the gate at a record clip, many of them surging by 50% or more in the first day of trading. If the real estate bubble were not enough, that hyperactive IPO market looks very similar to what we witnessed in the 1990s during the dot-com boom.

On the other hand, it is hard to ignore the potential of China — and of all emerging markets, for that matter. Already, developing countries account for half of the world’s gross domestic product — and these countries are still growing. Meanwhile, G-8 countries continue to try to rescue their banking systems, trying to find painless ways to exit their stimulus packages and predicting, at best, slow growth.

On the surface, these points of view may appear to conflict. But what we are really talking about is a timing issue. Over the long term, it seems clear that world economic power is shifting from the G-8 regime to emerging markets. But in the shorter term, one could easily argue that no matter how rosy the long-term forecast, it does not justify the recent surge in market activity among emerging markets — most notably, China’s.

This is particularly true if investors turn out to be banking on G-8 growth that does not materialize. Which is to say the euphoria generated by early signs of economic recovery may not last. And with China now a dominant player in the world economy, any fallout stemming from a Chinese domestic meltdown will be felt most acutely in emerging markets, although it will surely extend across the globe.

If you have not entered the emerging-market euphoria, you would be well advised to wait awhile. If you own emerging-market exchange-traded funds, which offer a liquid options market, you might consider hedging your bets — at least, for the near term.

The most widely utilized emerging-market ETF is iShares MSCI emerging markets index fund (recent price: US$36.12; 39.42% year-to-date return, including dividends). With this ETF, you could write (sell) the December 36 calls at US$3.10 or buy the September 34 puts at US$0.85.

If you prefer dealing with a specific country’s ETFs, one of the strongest performers year-to-date is iShares MSCI Brazil index fund (recent price US$60.81; 67.6% year-to-date return).

If you own this ETF, look at writing the December 60 calls at US$6.20 or buying the September 58 puts at US$2.10.

For those exposed to China, you could look at puts on China’s stock market through optionable ETFs, such as iShares MSCI Hong Kong index fund (recent price US$15.10). The December 15 puts at US$1.30 look like a reasonable trade.

@page_break@Another ETF is iShares FTSE/Xinhua China 25 index fund (recent price US$41.81). With this ETF, I would look at the FXI November 40 puts at US$3.

As an alternative, you could write the September 40 calls at US$3.30.

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