Country and Political Risk

							Country and Political Risk


   International Finance 250
   Dick Sweeney
Adjusting for “Risk”
   The standard NPV formula is
   NPV = - CF0 + t=1 (E CFt) / (1 + RR)t
   Suppose that the project is in a country
    where “a lot of bad things” can happen
   Do you reduce (E CFt)? Increase RR? Both?
   Sometimes the “bad things” reduce the
    probability of good outcomes, increase the
    probability of bad outcomes
    Adjusting for “Risk” (cont.)
         Reduce (E CFt)
   Sometimes the “bad things” increase spread of
    distribution of actual returns
         An increase in Rproj
   What about discount rate when Rproj rises?
   In APMs, it is beta risk that matters—in CAPM,
    market-beta risk,
        Rm,Rproj = Rm,Rproj (Rproj / Rm)
Adjusting for “Risk” (cont.)
   If Rproj rises, the effect on Rm,Rproj depends
    on size of Rm,Rproj
   Often the Rm,Rproj is small, Rm,Rproj  0 
    Rm,Rproj  0 and the effect on Rm,Rproj is
    close to zero
   RR = rf + Rm,Rproj (ERM - rf): if Rm,Rproj 
    0, then RR  rf and effect on RR of rise in
    Rproj is about zero
   Diamond mining in Congo
    Country Risk Premium
   Are you using CAPM?
   Then, RR = rf + Rm,Rproj (ERM - rf): no country risk
    premium, that’s all there is to it
   If you add country risk premium, RPc, then you simply
    are not using CAPM:
         RR = rf + Rm,Rproj (ERM - rf) + RPC
   When do fans of RPC suggest adding it? Only when you
    have to estimate Rm,Rproj using U.S. data for RRproj
   If you use foreign-country data, they say, “Do not add
    country risk premium”
Country Risk Premium (cont.)
   Example: dishware in Indonesia
   Rdw,Ind is rate of return in USD on index of
    dishware firms in Indonesia
   Market model is
       Rdw,Ind,t = a + b RRm,world,t + et
   Estimate of b is estimate of , do not add RPC
   b contains effects of Indonesia country and
    political risk, no further adjustment needed
    Country Risk Premium (cont.)
   What if use U.S. dishware index, run
        Rdw,US,t = a1 + b1 RRm,world,t + e1,t
   Then, estimate of b1 does not contain effects
    of Indonesia country or political risk
   May want to add RPC
   Alternative: Run
        RJSE,t = a2 + b2 RRm,world,t + e2,t
   b2 gives estimate of average beta on JSE
    Country Risk Premium (cont.)
   Adjust by ratio of dw,US to average beta in
    U.S., about unity (is unity if use U.S. market)
   Thus, estimate of beta for dishware industry
    might be b2 x dw,US
   Example: Suppose b2 = 0.50 and dw,US = 0.80
   Then estimate of dw,Ind = b2 x dw,US = 0.50 x
    0.80 = 0.40
   Or, if dw,US = 1.50, then dw,Ind = 0.50 x 1.50
    = 0.75
    Un-levering, Re-levering Beta
   In RJSE,t = a2 + b2 RRm,world,t + e2,t, b2 gives estimate of
    beta of average firm in JSE, including effects of
    leverage
   If your project has different leverage from average
    JSE firm, have to un-lever the beta and re-lever it
   b2 is estimate of levered beta, related to unlevered
    beta in simple case as
   unlev,Ind = b2 x (EquityJSE / ValueJSE)
   If b2 = 0.60 and (EquityJSE / ValueJSE) = 0.50
    [so (DebtJSE / ValueJSE) = 0.50] , then
         unlev,Ind = 0.60 x 0.50 = 0.30
Un-levering, Re-levering Beta (cont.)
   Suppose you will use (Equityproj / Valueproj) = 0.25,
    thus (Debtproj / Valueproj) = 0.75 [high relative to 0.50]
   Then, (Equityproj / Valueproj) x lev,proj = unlev,Ind
         0.25 x lev,proj = 0.30
   lev,proj = 0.30 / 0.25 = 1.20
   Note, this 1.20 is much larger than b2 = 0.60
   This follows from (Equityproj / Valueproj) = 0.25 but
    (EquityJSE / ValueJSE) = 0.50, or
       (EquityJSE / ValueJSE) / (Equityproj / Valueproj)
         = 0.50 / 0.25 = 2.0
Leverage in East Asia Stock Markets
    For six East Asia countries, estimated average leverage ratios,
     debt to value, are:
    Indonesia                     0.47
    Korea                         0.71
    Malaysia                      0.36
    Philippines                   0.39
    Taiwan                        0.43
    Thailand                      0.47
    The firms included in the ratio are all listed, and are the 70 to
     80 largest firms. The estimates are for 1994 - 1995. (IMF
     Working Paper, No. 135, Oct. 1999.)