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Is there more risk in investing in a Malaysian or Brazilian stock than there is in investing in the United States?A Modified Historical Risk Premium While historical risk premiums for markets outside the United States cannot be used in risk models, we still need to estimate a risk premium for use in these markets. To approach this estimation question, let us start with the basic proposition that the risk premium in any equity market can be written as: Equity Risk Premium = Base Premium for Mature Equity Market + Country Premium The country premium could reflect the extra risk in a specific market. This boils down our estimation to answering two questions: * What should the base premium for a mature equity market be? * Should there be a country premium, and if so, how do we estimate the premium? To answer the first question, we will make the argument that the US equity market is a mature market and that there is sufficient historical data in the United States to make a reasonable estimate of the risk premium. In fact, reverting back to our discussion of historical premiums in the US market, we will use the geometric average premium earned by stocks over treasury bonds of 5.51% between 1928 and 2000. We chose the long time period to reduce standard error, the treasury bond to be consistent with our choice of a riskfree rate and geometric averages to reflect our desire for a risk premium that we can use for longer term expected returns. On the issue of country premiums, there are some who argue that country risk is diversifiable and that there should be no country risk premium. We will begin by looking at the basis for their argument and then consider the alternative view that there should be a country risk premium. We will present two approaches for estimating country risk premiums, one based upon country bond default spreads and one based upon equity market volatility. Should there be a country risk premium? Is there more risk in investing in a Malaysian or Brazilian stock than there is in investing in the United States? The answer, to most, seems to be obviously affirmative. That, however, does not answer the question of whether there should be an additional risk premium charged when investing in those markets. Note that the only risk that is relevant for the purpose of estimating a cost of equity is market risk or risk that cannot be diversified away. The key question then becomes whether the risk in an emerging market is diversifiable or non-diversifiable risk. If, in fact, the additional risk of investing in Malaysia or Brazil can be diversified away, then there should be no additional risk premium charged. If it cannot, then it makes sense to think about estimating a country risk premium. But diversified away by whom? Equity in a Brazilian or Malaysian firm can be held by hundreds or thousands of investors, some of whom may hold only domestic stocks in their portfolio, whereas others may have more global exposure. For purposes of analyzing country risk, we look at the marginal investor - the investor most likely to be trading on the equity. If that marginal investor is globally diversified, there is at least the potential for global diversification. If the marginal investor does not have a global portfolio, the likelihood of diversifying away country risk declines substantially. Stulz (1999) made a similar point using different terminology. He differentiated between segmented markets, where risk premiums can be different in each market because investors cannot or will not invest outside their domestic markets, and open markets, where investors can invest across markets. In a segmented market, the marginal investor will be diversified only across investments in that market; whereas in an open market, the marginal investor has the opportunity (even if he or she does not take it) to invest across markets. Even if the marginal investor is globally diversified, there is a second test that has to be met for country risk to not matter. All or much of country risk should be country specific. In other words, there should be low correlation across markets. Only then will the risk be diversifiable in a globally diversified portfolio. If, on the other hand, the returns across countries have significant positive correlation, country risk has a market risk component and is not diversifiable and can command a premium. Whether returns across countries are positively correlated is an empirical question. Studies from the 1970s and 1980s suggested that the correlation was low and this was an impetus for global diversification. Partly because of the success of that sales pitch and partly because economies around the world have become increasingly intertwined over the last decade, more recent studies indicate that the correlation across markets has risen. This is borne out by the speed at which troubles in one market, say Russia, can spread to a market with little or no obvious relationship, say Brazil. So where do we stand? We believe that while the barriers to trading across markets have dropped, investors still have a home bias in their portfolios and that markets remain partially segmented. While globally diversified investors are playing an increasing role in the pricing of equities around the world, the resulting increase in correlation across markets has resulted in a portion of country risk being nondiversifiable or market risk. In the next section, we will consider how best to measure this country risk and build it into expected returns. Measuring Country Risk Premiums If country risk matters and leads to higher premiums for riskier countries, the obvious follow-up question becomes how we measure this additional premium. In this section, we will look at two approaches. The first builds on default spreads on country bonds issued by each country whereas the second uses equity market volatility as its basis. 1. Default Risk Spreads While there are several measures of country risk, one of the simplest and most easily accessible is the rating assigned to a countrys debt by a ratings agency (S&P, Moodys and IBCA all rate countries). These ratings measure default risk (rather than equity risk), but they are affected by many of the factors that drive equity risk - the stability of a countrys currency, its budget and trade balances and its political stability, for instance12. The other advantage of ratings is that they come with default spreads over the US treasury bond. For instance, table 7.5 summarizes the ratings and default spreads for Latin American countries on June 2000. The market spreads measure the difference between dollar-denominated bonds issued by the country and the U.S. treasury bond rate. While this is a market rate and reflects current expectations, country bond spreads are extremely volatile and can shift significantly from day to day. To counter this volatility, we have estimate typical spreads by averaging the default spreads of all countries in the world with the specified rating over and above the appropriate riskless. These spreads tend to be less volatile and more reliable for long term analysis. Analysts who use default spreads as measures of country risk typically add them on to both the cost of equity and debt of every company traded in that country. For instance, the cost of equity for a Brazilian company, estimated in U.S. dollars, will be 4.83% higher than the cost of equity of an otherwise similar U.S. company. If we assume that the risk premium for the United States and other mature equity markets is 5.51%, the cost of equity for an average Brazilian company can be estimated as follows (with a U.S. Treasury bond rate of 5% and a beta of 1.2). Cost of equity = Riskfree rate + Beta *(U.S. Risk premium) + Default Spread = 5% + 1.2 (5.51%) + 4.83% = 16..34% In some cases, analysts add the default spread to the U.S. risk premium and multiply it by the beta. This increases the cost of equity for high beta companies and lowers them for low beta firms. While ratings provide a convenient measure of country risk, there are costs associated with using them as the only measure. First, ratings agencies often lag markets when it comes to responding to changes in the underlying default risk. Second, the fact that the ratings agency focus on default risk may obscure other risks that could still affect equity markets. What are the alternatives? There are numerical country risk scores that have been developed by some services as much more comprehensive measures of risk. The Economist, for instance, has a score that runs from 0 to 100, where 0 is no risk, and 100 is most risky, that it uses to rank emerging markets. Alternatively, country risk can be estimated from the bottom-up by looking at economic fundamentals in each country. This, of course, requires significantly more information than the other approaches. Finally, default spreads measure the risk associated with bonds issued by countries and not the equity risk in these countries. Since equities in any market are likely to be more risky than bonds, you could argue that default spreads understate equity risk premiums. The Danger of Double Counting Risk When assessing country risk, there is a substantial risk that the same risk may be counted more than once in a valuation. For instance, there are analysts who use the dollardenominated bonds issued by a country - the Brazilian C-Bond, for instance - as the riskfree rate when estimating cost of equity for Brazilian companies. The interest rate on this bond already incorporates the default spreads discussed in the section above. If the risk premium is also adjusted upwards to reflect country risk, there has been a double counting of the risk. This effect is made worse when betas are adjusted upwards and cash flows are adjusted downwards (a process called haircutting) because of country risk. 2. Relative Standard Deviations There are some analysts who believe that the equity risk premiums of markets should reflect the differences in equity risk, as measured by the volatilities of these markets. A conventional measure of equity risk is the standard deviation in stock prices; higher standard deviations are generally associated with more risk. If you scale the standard deviation of one market against another, you obtain a measure of relative risk. This relative standard deviation when multiplied by the premium used for U.S. stocks should yield a measure of the total risk premium for any market. Equity risk premiumCountry X???Risk PremumUS *Relative Standard Deviation Country X Assume, for the moment, that you are using a mature market premium for the United States of 5.51% and that the annual standard deviation of U.S. stocks is 20%. If the annual standard deviation of Indonesian stocks is 35%, the estimate of a total risk premium for Indonesia would be as follows. The country risk premium can be isolated as follows: Country Risk PremiumIndonesia??9 . 6 4 % - 5 . 5 1?% 4.13% While this approach has intuitive appeal, there are problems with using standard deviations computed in markets with widely different market structures and liquidity. There are very risky emerging markets that have low standard deviations for their equity markets because the markets are illiquid. This approach will understate the equity risk premiums in those markets. The second problem is related to currencies since the standard deviations are usually measured in local currency terms; the standard deviation in the U.S. market is a dollar standard deviation, whereas the standard deviation in the Indonesian market is a rupiah standard deviation. This is a relatively simple problem to fix, though, since the standard deviations can be measured in the same currency - you could estimate the standard deviation in dollar returns for the Indonesian market. 3. Default Spreads + Relative Standard Deviations The country default spreads that come with country ratings provide an important first step, but still only measure the premium for default risk. Intuitively, we would expect the country equity risk premium to be larger than the country default risk spread. To address the issue of how much higher, we look at the volatility of the equity market in a country relative to the volatility of the bond market used to estimate the spread. This yields the following estimate for the country equity risk premium. To illustrate, consider the case of Brazil. In March 2000, Brazil was rated B2 by Moodys, resulting in a default spread of 4.83%. The annualized standard deviation in the Brazilian equity index over the previous year was 30.64%, while the annualized standard deviation in the Brazilian dollar denominated C-bond was 15.28%. The resulting country equity risk premium for Brazil is as follows: Note that this country risk premium will increase if the country rating drops or if the relative volatility of the equity market increases. Why should equity risk premiums have any relationship to country bond spreads? A simple explanation is that an investor who can make 11% on a dollar-denominated Brazilian government bond would not settle for an expected return of 10.5% (in dollar terms) on Brazilian equity. Playing devils advocate, however, a critic could argue that the interest rate on a country bond, from which default spreads are extracted, is not really an expected return since it is based upon the promised cash flows (coupon and principal) on the bond rather than the expected cash flows. In fact, if we wanted to estimate a risk premium for bonds, we would need to estimate the expected return based upon expected cash flows, allowing for the default risk. This would result in a much lower default spread and equity risk premium. Both this approach and the previous one use the standard deviation in equity of a market to make a judgment about country risk premium, but they measure it relative to different bases. This approach uses the country bond as a base, whereas the previous one uses the standard deviation in the U.S. market. This approach assumes that investors are more likely to choose between Brazilian bonds and Brazilian equity, whereas the previous one approach assumes that the choice is across equity markets. |
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