International Value Creation
description
Transcript of International Value Creation
International Value CreationInternational Value Creation
Campbell R. HarveyDuke University
andNational Bureau of Economic Research
DRAFT
International ValueInternational Value1. Setting
• A critical component in implementing EVA in international context is knowing the appropriate hurdle rates.
• Each country has its own risk characteristics which need to be taken into account.
International ValueInternational Value1. Setting
• Unfortunately, there is widespread disagreement over approaches to international valuation
• Different methods provide sharply different hurdle rates in international context
International ValueInternational Value1. Setting
• Disagreement comes at a bad time with growth in global investment
International ValueInternational Value2. Goals
• Motivation
• Defining Country Risk
• Methods of Calculating Hurdle Rates
• Implementing the International Cost of Capital
• Country Risk and EVA
International ValueInternational Value3. Motivation
• Dramatic internationalization of world
– Economic integration through increased trade.
– Financial integration through liberalization of capital markets
International ValueInternational Value3. Motivation
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4. Motivation Advantages• A broader selection of company targets• Access to growth and innovation in new markets• Lower operating costs
– Labor– Purchased materials
• Reduced taxes in selected markets• Reduced borrowing costs• Investment incentives• Reduced risk: Diversification among less correlated markets
International ValueInternational Value
4. Motivation Advantages
Diversification argument somewhat controversial
• Traditional view is that shareholders can do their own diversification.
• Modern view is that diversification reduces the volatility of a company’s cash flows and gives it the flexibility to pursue the most profitable projects–That is, if a company was not diversified, a negative current cash flow might exclude it from investing in high value projects (because the cost of debt and equity financing is high)
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0.10.20.30.40.50.60.70.80.9
AUSTRALIA
AUSTRIA
BELGIUM
CANADA
DENMARK
FINLAND
FRANCE
GERMANY
HONGKONG
IRELAND
ITALY
JAPAN
NETHERLND
NORWAY
NW Z
EALND
SINGAPORE
SPAIN
SWEDEN
SWIS
S
U.K.
USA
Averag
e
Since 1980 Since 1990
International ValueInternational Value
4. Motivation Correlations of World Returns and Developed Markets
Data through June 1998
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Argen
tina
Brazil
Chile
Colombia
Greece
India
Indones
ia
Jord
anKorea
Mala
ysia
Mex
ico
Nigeria
Pakist
an
Philippines
Portugal
Taiwan
Thailan
d
Turkey
Venez
uela
Zimbab
we
Average
Since 1980 Since 1990
International ValueInternational Value
4. Motivation Correlations of World Equity Returns and Emerging Markets
Data through June 1998
Disadvantages• Increased operating cost expectations
– Taxes, tariffs and quotas– Transportation/shipping costs– Infrastructure costs– Organizational costs
• Increased or different risk expectations– Lack of information– Different equity return premiums– Currency fluctuations– Liquidity risk– Sovereign risk (e.g. expropriation and restrictions on
repatriation of capital)
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4. Motivation
0255075
100125150
Anam Electronics Korean Air Tongyang Moolsan
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4. Motivation Investment of $100 in three Korean companies
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5. Valuation Approaches Many common methods
Valuation Method Calculation Value TypeNet Tangible Assets V = Assets - Liabilities Break Up
Comparable Multiple- Price/Earnings- Market/Book- Price/Sales
V = P/E x EarningsV = M/B x BookV = P/Sales x Sales(Prices are current)
Current
Comparable Transaction - Premium to market - Premium to book - Acquisition multiple
V = Price/Book x BookV = Price/Market x MarketV = P/E x EarningsV = P/E x EarningsV = P/Sales x Sales(Prices from acquisitions)
Acquisition
DCF with Synergies V = CF (1+K)Cash flows include anticipated synergies and all real options
Acquisition
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5. Valuation Approaches Ratios often not comparable across countries
Country Price-EarningsRatio
Price-to-BookRatio
DividendYield
USJapanUKGermanyFranceArgentinaBrazilMexicoKorea
27.22123.9619.4832.4828.9712.938.5712.74226.53
4.671.823.754.083.071.430.751.830.45
1.420.892.451.661.983.274.421.822.36
MSCI data as of June 1998
• DCF can be used to calculate business plan, capital investment, and acquisition values
• The same factors affect value around the globe– Cash flows– Timing– Risk
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6. Global DCF Analysis
Value
– Liquidity– Repatriation
Limits
– Systematic– Currency– Information– Sovereign/
Credit Risk
– Currency Translation
– Accounting Adjustments
– Taxes
Cash Flow Timing Risk
Applying DCF to international opportunities requires adjustments to each component of value
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6. Global DCF Analysis
Multistep process to apply DCF analysis to international opportunities
Determine “nominal” or
“real” forecast basis
Forecast local currency cash
flows
Adjust cash flows for specific risks
Translate into U.S. cash flows using forward
rates
Compute discount rate
adjust residual value, calculate
present value
Step 1 Step 2 Step 3 Step 4 Step 5
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6. Global DCF Analysis
Calculate cash flows for international investment
Reflect systematic risks
Determine “nominal” or
“real” forecast basis
Forecast local currency cash
flows
Adjust cash flows for risks
Translate into U.S. cash flows using forward
rates
Compute discount rate
adjust residual value, calculate
present value
Step 1 Step 2 Step 3 Step 4 Step 5
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6. Global DCF Analysis
Unpredictable: Hyper-Inflationary
Economy
Predictable:Low to Moderate
Inflation Economy
Forecast “real” cash flows (backout or exclude
inflation)
Forecast “nominal” cash flows
(include inflation)
Discount cash flows with the “real”
economic valuation rate
Discount cash flows with the “nominal” economic
valuation rate
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6. Global DCF Analysis
Determine “nominal” or
“real” forecast basis
Forecast local currency cash
flows
Adjust cash flows for risks
Translate into U.S. cash flows using forward
rates
Compute discount rate
adjust residual value, calculate
present value
Step 1 Step 2 Step 3 Step 4 Step 5
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6. Global DCF Analysis
Forecast cash flows in local currency
• Financial data is most often collected in local currency
• It has more relevance to the local management
• It facilitates reflecting local inflation in revenues and costs• It makes calculation of taxes, repatriation limits and currency
exposure easier• Conversion to US dollars is easier, simpler, and less prone to
error when done at the end of the local currency analysis• Works best in moderate to low inflation countries
International ValueInternational Value
6. Global DCF Analysis
When valuing global opportunities only include cash flows that can be remitted to the parent
• Governments sometimes set limits on cash out flows from their countries
– The amount of cash flow– The types of cash flows (e.g. dividends, profits and transfer costs)– When they can be taken out (e.g. none for five years)
• If repatriation is uncertain, estimate the probability of repatriation and calculate the expected value of future cash flows
• If delayed, cash flows should be included at the time they become available to shareholders
• However, if valuing for sale, include all cash flows, compute NPV, and then estimate what can be remitted
International ValueInternational Value
6. Global DCF Analysis
Determine “nominal” or
“real” forecast basis
Forecast local currency cash
flows
Adjust cash flows for risks
Translate into U.S. cash flows using forward
rates
Compute discount rate
adjust residual value, calculate
present value
Step 1 Step 2 Step 3 Step 4 Step 5
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6. Global DCF Analysis
Risk that a country's government might take actions that reduce the value of a firm to its current owners (e.g. expropriation, tax hikes)
Sovereign: country credit rating
CountrySystematic
Devaluation/ Revaluation
Risk that a drop in the value of a firm's currency will reduce the firm's value
CountrySystematic
Liquidity The risk that the owners might not be able to sell
assets when desiredSpecific
SpecificCurrency The risk that volatility in currency exchange rates causes a target's value to fluctuate
Inflation The risk that inflation will rise unexpectedly, reducing the present value of future international cash flows
Country Systematic
Interest Rate The risk that interest rates will rise unexpectedly,
reducing the present value of future international cash flows
CountrySystematic
Information The risk that limited or biased information might
lead you to over value a target companySpecific
International RisksRisk Description Risk Type Cash Flow Economic
Valuation Rate
Where to Reflect
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6. Global DCF Analysis
International specific risks can be incorporated into expected cash flows using scenario analysis
Steps for Scenario Analysis
1 Identify risks and estimate their probabilities of occurrence
2 Estimate when they are most likely to occur
3 Identify the impact of each risk on expected cash flows
4 Calculate expected value of cash flows by weighting the cash flows in each scenario by the probability the scenario occurs
Note: The same should be done for NOPAT when calculating residual value using the perpetuity method
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6. Global DCF Analysis
EXAMPLE
Incorporating information, currency transaction and liquidity risks into “Global-Co’s”cash flows forecast
Risks Estimated Probability Estimated Cash Flow Impact
Probability Adjustment
Estimated Timing
Currency Risk 100% -10% -10% Immediate
Information (i.e. market acceptance)
20% +5% 1% 2 years
Liquidity 5% -100% -5% 3 years
Risk Information
Sample Cash Flow Adjustment
Year 1 Year 2 Year 3 Year 4
Base Case Cash Flows$ Millions
$37 $50 $68 $83
Currency RiskInformationLiquidity
-10% 0% 0%
-10% 1% 0%
-10% 1% -5%
-10% 1% -5%
Total Adjustments -10% -9% -14% -14%
Adjusted Cash Flows ($M) $33 $46 $58 $72
International ValueInternational Value
6. Global DCF Analysis
Determine “nominal” or
“real” forecast basis
Forecast local currency cash
flows
Adjust cash flows for risks
Translate into U.S. cash flows using forward
rates
Compute discount rate
adjust residual value, calculate
present value
Step 1 Step 2 Step 3 Step 4 Step 5
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6. Global DCF Analysis
Future cash flows can be translated using exchange rate forecasts based on parity relationships
Example: Converting Forecast Peso Cash Flows into US$ Cash Flows
US$ Inflation* 1.4 1.4 1.4 1.4
Mexican Peso Inflation* 15.3 15.3 15.3 15.3
1 + i US$
1 + i Peso 0.8794 0.7733 0.6801 0.5981
Spot US$/Peso Rate 0.1177 0.1177 0.1177 0.1177
Forward US$/Peso Rate 0.1035 0.0910 0.0801 0.0704(Parity Factor x Spot Rate)
Peso Cash Flows 320 500 730 1020
US$ Cash Flows 33 46 58 72
*For calculation simplicity, same inflation rates were used each year
Year 1 Year 2 Year 3 Year 4
Parity Factor
=
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6. Global DCF Analysis
When applied correctly, forecasting in US$ or local currency results in the same shareholder
value independent of the choice of currency
Assumptions:US Inflation Rate 1.4%Mexican Inflation Rate 15.3%US Cost of Capital 10.0%Mexican Cost of Capital 25.1%Spot Rate (US$/Peso) 0.1177
Cash Flows
Residual Value
Discount Factor
Present Value
Cumulative PV
Year1
Year2
Year3
Year4
320 500 730 1,020
4,067
0.7995 0.6392 0.5110 0.4086
256 320 373 2,078
Peso 3,027
Cash Flows
Residual Value
Discount Factor
Present Value
Cumulative PV
Year1
Year2
Year3
Year4
33 46 58 72
286
0.9091 0.8264 0.7513 0.6830
30 38 44 245
$356
Forward Rates 0.1035 0.0910 0.0801 0.0704
Peso Forecast US Dollar Forecast
Equivalent at 0.1177 US$/Peso spot exchange rate
International ValueInternational Value
6. Global DCF Analysis
Cumulative PV $556
Applying today’s spot rate to the forecast grosslyoverstates the value if projected local inflation exceeds US inflation -- in this example by 56%!
Assumptions:US Inflation Rate 1.4%Mexican Inflation Rate 15.3%US Cost of Capital 10.0%Mexican Cost of Capital 25.1%Spot Rate (US$/Peso) 0.1177
Cash Flows
Residual Value
Discount Factor
Present Value
Year1
Year2
Year3
Year4
38 59 86 120
478
34 49 65 409
Cash Flows
Residual Value
Discount Factor
Present Value
Year1
Year2
Year3
Year4
33 46 58 72
286
0.9091 0.8264 0.7513 0.6830
30 38 44 245
Forward Rates 0.1035 0.0910 0.0801 0.0704
US Dollar Forecast(incorrectly using Today’s Spot Rate)
US Dollar Forecast(using Forward Rates)
Spot Rate 0.1177 0.1177 0.1177 0.1177
0.9091 0.8264 0.7513 0.6830
Cumulative PV $356Cumulative PV $556 Cumulative PV $356
International ValueInternational Value
6. Global DCF Analysis
Forward Rates
Used to bring cash flows to U.S. dollars
Determined by differences in interest rates
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6. Global DCF Analysis
Forward Rates
Covered Interest Rate Parity is enforced by arbitrage.
International ValueInternational Value
6. Global DCF Analysis
years t ofmaturity with yields bonddiscount pureYen andDollar ,
($/Y) rate exchangespot Current
future in the yearsin t delivery for ($/Y) rate exchange Forward
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Forward Rates
Example.
Suppose a German 12-month T-bill yield is 8% and the U.S.12-month T-bill yield is 4%.
Does it make sense for the U.S. investor to invest in the higher yielding German T-bill?
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6. Global DCF Analysis
Forward Rates
Answer: No
If you invest in the German T-bill, you will take on some currency risk. Suppose you invested 100m DM and at the end of the year you will receive 108m DM.
To hedge this risk, you will sell forward 108m DM today.
The forward rate will guarantee that you lock in a 4% return - which is no different than buying the U.S. T-bill!
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6. Global DCF Analysis
Forward Rates
Rates are readily available for the major currencies from major banks and trading houses.
Example: Bloomberg screen for $/DM
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6. Global DCF Analysis
International ValueInternational Value
6. Global DCF Analysis
Forward Rates
If no quoted forward rates:Use forward rate equation and interest rates to backout forward rates.
If no quoted interest rates:Use inflation forecasts and add real economic growth forecast tocreate nominal interest rates.
International ValueInternational Value
6. Global DCF Analysis
Determine “nominal” or
“real” forecast basis
Forecast local currency cash
flows
Adjust cash flows for risks
Translate into U.S. cash flows using forward
rates
Compute discount rate
adjust residual value, calculate
present value
Step 1 Step 2 Step 3 Step 4 Step 5
International ValueInternational Value
6. Global DCF Analysis
Many different approaches:• Identical Cost of Capital (all locations)• World CAPM or Multifactor Model (Sharpe-Ross)• Segmented/Integrated (Bekaert-Harvey)• Bayesian (Ibbotson Associates)• Country Risk Rating (Erb-Harvey-Viskanta)• CAPM with Skewness (Harvey-Siddique)
International ValueInternational Value7. Economic Valuation Rate
• Goldman-integrated sovereign yield spread model• Goldman-segmented• Goldman-EHV hybrid• CSFB volatility ratio model• CSFB-EHV hybrid
International ValueInternational Value7. Economic Valuation Rate
Identical Cost of Capital
• Ignores the fact that shareholders require different expected returns for different risks
International ValueInternational Value7. Economic Valuation Rate
Identical Cost of Capital
• Risky investments get evaluated with too low of a discount rate (and look better than they should)
• Less risky investments get evaluated with too high of a discount rate (and look worse than they are)
• Hence, method destroys valueAvoid
International ValueInternational Value7. Economic Valuation Rate
World CAPM• Sharpe’s Capital Asset Pricing Model is the
mainstay of economic valuation• Simple formula• Intuition is that required rate of return depends on
how the investment contributes to the volatility of a well diversified portfolio
International ValueInternational Value7. Economic Valuation Rate
World CAPM• Expected discount rate (in U.S. dollars) on
investment that has average in a country = riskfree + x world risk premium
• Beta is measured relative to a “world” portfolio• OK for developed markets if we allow risk to
change through time (Harvey 1991)
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World CAPM
• Strong assumptions needed• Perfect market integration• Mean-Variance analysis implied by utility
assumptions• Fails in emerging markets
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Returns and Beta from 1970
R2 = 0.013
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0.1
0.2
0.3
0.4
0.5
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Beta
Ave
rage
ret
urns
Should be a positive relation, with higher risk associated with higher return!But perhaps we should look at a more recent sample of data.
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Returns and Beta from 1990
R2 = 0.0211
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Beta
Ave
rage
ret
urns
Still goes the wrong way - even with data from 1990!
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Returns and Beta from 1990 through 1998:03
R2 = 0.1064
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Beta
Ave
rage
ret
urns
Incorporating the Asian crisis makes the model look even worse.
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World CAPM
• OK to use in developed markets• May give unreliable results in smaller, less liquid
developed markets
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Segmented/Integrated CAPM
• CAPM assumes that markets are perfectly integrated– foreign investors can freely invest in the local market– local investors can freely invest outside the local market
• Many markets are not integrated so we need to modify the CAPM
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Segmented/Integrated CAPM
• Bekaert and Harvey (1995)• If market integrated, world CAPM holds• If market segmented, local CAPM holds• If going through the process of integration, a
combination of two holds
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Segmented/Integrated CAPM
Estimate world beta and expected return
= riskfree + w x world risk premium
Estimate local beta and expected return
= local riskfree + L x local risk premium
International ValueInternational Value7. Economic Valuation Rate
Segmented/Integrated CAPM
• Put everything in common currency terms• Add up the two components.
EVR= w[world EVR] + (1-w)[local EVR]• Weights, w, determined by variables that proxy
for degree of integration, like size of trade sector and equity market capitalization to GDP
International ValueInternational Value7. Economic Valuation Rate
Segmented/Integrated CAPM
• Weights are dynamic, as are the risk loadings and the risk premiums
• Downside: hard to implement; only appropriate for countries with equity markets
• Recommendation: Wait
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Ibbotson Associates(Recognized expert in cost of capital calculation)
• Approach recognizes that the world CAPM is not the best model
• Ibbotson approach combines the CAPM’s prediction with naïve prediction based on past performance.
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Ibbotson Associates• STEPS1 Calculate world risk premium=U.S. risk premium
divided by the beta versus the MSCI world (=7.8%)
2 Estimate country beta versus world index3 Multiply this beta times world risk premium
International ValueInternational Value7. Economic Valuation Rate
Ibbotson Associates
4 Add in 0.5 times the ‘intercept’ from the initial regression. “This additional premium represents the compensation an investor receives for taking on the considerable risks of the emerging markets that is not explained by beta alone.”
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Ibbotson Associates
• Gives unreasonable results in some countries• Only useful if equity markets exist• Ibbotson Associates does not even use itRecommendation: Do not use this version.
Ibbotson is working on a better model to be available soon
International ValueInternational Value7. Economic Valuation Rate
CAPM with Skewness
• For years, economists did not understand why people spend money on lottery tickets and horse betting
• The expected return is negative and the volatility is high
• Behavioral explanations focused on “risk loving”
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CAPM with Skewness
• But this is just preference for positive skewness (big positive outcomes)
• People like positive skewness and dislike negative skewness (downside)
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CAPM with Skewness
• Most are willing to pay extra for an investment that adds positive skewness (lower hurdle rate), e.g. investing in China?
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CAPM with Skewness
• Harvey and Siddique (1998) tests of a model that includes time-varying skewness risk
• Bekaert, Erb, Harvey and Viskanta detail the implications of skewness and kurtosis in emerging market stock selection
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CAPM with Skewness
• Model still being developed• Skewness similar to many “real options” that are
important in project evaluationRecommendation: Wait
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Goldman-Integrated
• This model is widely used by McKinsey, Salomon and many others.
• Addresses the problem that the CAPM gives a discount rate too low.
• Solution: Add the sovereign yield spread
International ValueInternational Value7. Economic Valuation Rate
Goldman-Integrated
• The sovereign yield spread is the yield on a U.S. dollar bond that a country offers versus a U.S. Treasury bond of the same maturity
• The spread is said to reflect “country risk”
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Goldman-Integrated
STEPS• Estimate market beta on the S&P 500• Beta times historical US premium • Add sovereign yield spread plus the risk free
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Goldman-Integrated-EHV Hybrid
• Goldman model only useful if you have sovereign yield spread
• Use Erb, Harvey and Viskanta model to fit ratings on yield spread
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Real Yields and Institutional Investor Country Credit Ratings from 1990 through 1998:03
R2 = 0.8784
0.00%2.00%4.00%6.00%8.00%
10.00%12.00%14.00%
0 20 40 60 80 100
Rating
Rea
l Yie
lds
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Goldman-Integrated-EHV Hybrid
• You just need a credit rating (available for 136 countries now) and the EHV model will deliver the sovereign yield
International ValueInternational Value7. Economic Valuation Rate
Goldman-Integrated-EHV Hybrid
• Even adding this yield spread delivers a cost of capital that is unreasonably low in many countries
• While you can get the yield spread in 136 countries with the EHV method, you can only get risk premiums for those countries with equity markets
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Goldman-Segmented
• Main problem is the beta• It is too low for many risky markets• Solution: Increase the beta
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Goldman-Segmented
• Modified beta=standard deviation of local market return in US dollars divided by standard deviation of the US market return
• Beta times historical US premium • Add sovereign yield spread
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Goldman-Segmented
• Strange formulation. The usual beta is:
• Using volatility ratio implies that the Correlation=1 !!
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World
iWorldiWorldi devStd
devStdnCorrelatioBeta
.
.,,
Goldman-Segmented
• No economic foundation for modification• No clear economic foundation for method in
generalRecommendation: Not recommended
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CSFB
E[ri]=SYi + i{E[rus-RFus] x Ai} x Ki
• SYi = brady yield (use fitted from EHV)
i = the beta of a stock against a local index
Ai =the coefficient of variation (CV) in the local market divided by the CV of the U.S. market) where CV = /mean.
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CSFB
• No economic foundation• Complicated, nonintuitive and ad hocRecommendation: Avoid
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Country Risk Rating Model
• Erb, Harvey and Viskanta (1995)• Credit rating a good ex ante measure of risk• Impressive fit to data
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Country Risk Rating Model
• Erb, Harvey and Viskanta (1995)• Explore risk surrogates:
– Political Risk,
– Economic Risk,
– Financial Risk and
– Country Credit Ratings
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Country Risk Rating Model
Sources• Political Risk Services’ International Country Risk Guide
• Institutional Investor’s Country Credit Rating
• Euromoney’s Country Credit Rating
• Moody’s
• S&P
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International ValueInternational Value7. Economic Valuation Rate
Political risk. International Country Risk Guide% of
Individual % ofPolitical Points Index CompositeEconomic expectations vs. reality 12 12% 6%Economic planning failures 12 12% 6%Political leadership 12 12% 6%External conflict 10 10% 5%Corruption in government 6 6% 3%Military in politics 6 6% 3%Organized religion in politics 6 6% 3%Law and order tradition 6 6% 3%Racial and nationality tensions 6 6% 3%Political terrorism 6 6% 3%Civil war 6 6% 3%Political party development 6 6% 3%Quality of the Bureaucracy 6 6% 3%
Total Political Points 100 100% 50%
International ValueInternational Value7. Economic Valuation Rate
Financial risk. International Country Risk Guide
FinancialLoan Default or unfavorable loan restructuring 10 20% 5%Delayed payment of suppliers’ credits 10 20% 5%Repudiation of contracts by governments 10 20% 5%Losses from exchange controls 10 20% 5%Expropriation of private investments 10 20% 5%
Total Financial Points 50 100% 25%
International ValueInternational Value7. Economic Valuation Rate
Economic risk. International Country Risk Guide
EconomicInflation 10 20% 5%Debt service as a % of exports of goods and services 10 20% 5%International liquidity ratios 5 10% 3%Foreign trade collection experience 5 10% 3%Current account balance as a % of goods and services 15 30% 8%Parallel foreign exchange rate market indicators 5 10% 3%
Total Economic Points 50 100% 25%
Overall Points 200 100%
International ValueInternational Value7. Economic Valuation Rate
International Country Risk Guide Risk Categories
Risk Category Composite Score Range
Very High Risk 0.0-49.5
High Risk 50.0-59.5Moderate Risk 60.0-69.5
Low Risk 70.0-84.5
Very Low Risk 85.0-100.0
International ValueInternational Value7. Economic Valuation Rate
Institutional Investor’s Country Credit Ratings
OECD Emerging Rest of World1979 1994 1979 1994 1979 1994
Economic Outlook 1 1 2 3 3 4Debt Service 5 2 1 1 1 1Financial Reserves/CurrentAccount
2 3 4 4 4 3
Fiscal Policy 9 4 9 7 6 6Political Outlook 3 5 3 2 2 2Access to Capital Markets 6 6 7 9 8 9Trade Balance 4 7 5 5 5 5Inflow of Portfolio Investment 7 8 8 8 7 8Foreign Direct Investment 8 9 6 6 9 7
International ValueInternational Value7. Economic Valuation Rate
Ratings are correlated:
0102030405060708090
100
Inst
itut
iona
l Inv
esto
r C
CR
AA
+
AA
AA
-
A+ A A-
BB
B+
BB
B
BB
B-
BB
+
BB
BB
-
B+ B
NR
S&P Sovereign Ratings
International ValueInternational Value7. Economic Valuation Rate
Ratings are correlated:
0102030405060708090
100
Eur
omon
ey C
CR
AA
+
AA
AA
-
A+ A A-
BB
B+
BB
B
BB
B-
BB
+
BB
BB
-
B+ B
NR
S&P Sovereign Ratings
International ValueInternational Value7. Economic Valuation Rate
Ratings are correlated:
0102030405060708090
100
ICR
G C
ompo
site
AA
+
AA
AA
-
A+ A A-
BB
B+
BB
B
BB
B-
BB
+
BB
BB
-
B+ B
NR
S&P Sovereign Ratings
International ValueInternational Value7. Economic Valuation Rate
Ratings are correlated:
Risk Measure ChangesII CCR ICRGC ICRGP ICRGF ICRGE
II CCR -0.03 0.01 0.03 -0.09ICRGC 0.35 0.79 0.54 0.43ICRGP 0.30 0.83 0.25 0.06ICRGF 0.26 0.60 0.35 0.05ICRGE 0.10 0.52 0.24 0.25
Risk Measure Levels
International ValueInternational Value7. Economic Valuation Rate
ICRG ratings predict changes in II ratings:
Attribute Coefficient T-Stat R-SquareICRGC 0.2120 7.59 5.0%ICRGP 0.1244 5.67 2.8%ICRGF 0.0956 5.69 2.8%ICRGE 0.0833 4.65 1.9%
International ValueInternational Value7. Economic Valuation Rate
Ratings predict inflation:
00.1
0.20.30.40.5
0.60.70.8
0.91
0 20 40 60 80 100
II Rating September 1996
Infl
atio
n ex
pect
atio
ns f
or 1
997
International ValueInternational Value7. Economic Valuation Rate
Ratings correlated with wealth:
$0
$5,000
$10,000
$15,000
$20,000
$25,000
0 20 40 60 80 100
II ratings for 74 countries
Per
cap
ita
real
GD
P
International ValueInternational Value7. Economic Valuation Rate
Time-series of ratings:
0102030405060708090
100
Switzerland Italy Kuwait Argentina
Returns and Institutional Investor Country Credit Ratings from 1990
R2 = 0.2976
-0.1
0
0.1
0.2
0.3
0.4
0.5
0 20 40 60 80 100
Rating
Ave
rage
ret
urns
International ValueInternational Value7. Economic Valuation Rate
Fit is as good as it gets - lower rating (higher risk) commands higherexpected returns. Even in among US firms, our best model gets about 30% explanatory power.
Returns and Institutional Investor Country Credit Ratings from 1990 through 1998:03
R2 = 0.0937
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0 20 40 60 80 100
Rating
Ave
rage
ret
urns
International ValueInternational Value7. Economic Valuation Rate
Even with the turbulent Asian crisis returns, we still get an impressive fit.
Credit Rating Model
• Intuitive• Can be used in 136 countries, that is, in countries
without equity markets• Fits developed and emerging markets
International ValueInternational Value7. Economic Valuation Rate
Country Risk Rating ModelSTEPS:
EVR = risk free + 0.944 - 0.177 Log(IICCR)• Where Log(IICCR) is the natural logarithm of the
Institutional Investor Country Credit Rating
International ValueInternational Value7. Economic Valuation Rate
International ValueInternational Value7. Economic Valuation Rate
Easy to use:
0%
10%
20%
30%
40%
50%
60%
70%0 10 20 30 40 50 60 70 80 90 100
Rating
Hur
dle
rate
ICRGC IICCR:84 IICCR:79
International ValueInternational Value7. Economic Valuation Rate
Also predicts volatility:
R2 = 0.5033
0%
10%
20%
30%
40%
50%
60%
70%
0 20 40 60 80 100
Institutional Investor Country Credit Rating
An
nu
aliz
ed V
ola
tility
International ValueInternational Value7. Economic Valuation Rate
Fitted volatility:
0%
10%
20%
30%
40%
50%
60%
70%
80%
Rating
Exp
ecte
d vo
lati
lity
IICCR:84 IICCR:79
International ValueInternational Value7. Economic Valuation Rate
And correlation.
R2 = 0.6809
-20%
0%
20%
40%
60%
80%
100%
0 20 40 60 80 100
Institutional Investor Countyr Credit Rating
Co
rrela
tio
n w
ith
MS
CI
AC
Wo
rld
International ValueInternational Value7. Economic Valuation Rate
Fitted correlation.
-100%
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
Rating
Exp
ecte
d co
rrel
atio
n w
ith
wor
ld
IICCR:84 IICCR:79
International ValueInternational Value7. Economic Valuation Rate
Asian Crisis.
0102030405060708090
100
Jan-9
7
Mar-
97
May
-97
Jul-9
7
Sep-9
7
Nov-9
7
Jan-9
8
Mar-
98
May
-98
Jul-9
8
ICR
G r
atin
g
China Hong Kong India IndonesiaKorea Malaysia Pakistan PhilippinesSingapore Taiwan Thailand Russia
International ValueInternational Value7. Economic Valuation Rate
Asian Crisis.
60
65
70
75
80
85
90
Jan-9
7
Mar-
97
May
-97
Jul-9
7
Sep-9
7
Nov-9
7
Jan-9
8
Mar-
98
May
-98
Jul-9
8
Sep-9
8
ICR
G r
atin
g
Korea Malaysia Russia
Beginning of crisis
International ValueInternational Value7. Economic Valuation Rate
Value of US$100
020406080
100120140160180200
Jan-9
7
Mar-
97
May
-97
Jul-9
7
Sep-9
7
Nov-9
7
Jan-9
8
Mar-
98
May
-98
Jul-9
8
Sep-9
8
Val
ue o
f $1
00
Korea Malaysia Russia
Beginning of crisis
International ValueInternational Value7. Economic Valuation Rate
Value of local currency (indexed at 100)
0
20
40
60
80
100
120
Jan-9
7
Mar-
97
May
-97
Jul-9
7
Sep-9
7
Nov-9
7
Jan-9
8
Mar-
98
May
-98
Jul-9
8
Sep-9
8
Val
ue o
f $1
00
Korea Malaysia Russia
Beginning of crisis
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
Argentina Mexico Thailand
CAPMIbbotson EHVGS-EHVGS-SegCSFB-EHV
International ValueInternational Value8. Comparison of EVRs
68%
-20.00%-15.00%-10.00%
-5.00%0.00%5.00%
10.00%15.00%
20.00%25.00%30.00%
Slovakia Pakistan United States
CAPMIbbotson EHVGS-EHVGS-SegCSFB-EHV
537%
International ValueInternational Value8. Comparison of EVRs
Estimated Equity Risk Premia:Country Risk Models
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0 10 20 30 40 50 60 70 80 90 100
Country Risk Rating
Est
imate
d E
qu
ity R
isk
Prem
iaIICCR:1981IICCR:1985ICRGC:1985IICCR:1990ICRGC:1990
IICCR: Institutional Investor Country Credit RatingICRGC: International Country Risk Guide Composite RatingSee Table 2 for details.
Estimated Bond Risk Premia:Country Risk Models
-5%
0%
5%
10%
15%
20%
25%
30%
35%
0 10 20 30 40 50 60 70 80 90 100
Country RIsk Rating
Sp
rea
d o
ver U
S T
rea
sury IICCR
ICRGC
IICCR: Institutional Investor Country Credit RatingICRGC: International Country Risk Guide Composite RatingSee Table 2 for details.
Java Version
International ValueInternational Value8. Comparison of EVRs
Excel version
International ValueInternational Value8. Comparison of EVRs