1. Introduction. 2. The country risk, can it be diversified?

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1 HOW TO ASSESS COMPANY EXPOSURE TO COUNTRY RISK Brezeanu Petre Academy of Economic Studies, Bucharest, , Triandafil Cristina Maria Finance Doctoral School, Academy of Economic Studies, Bucharest, , Since globalization implied a keen interest for the Latin American, Eastern European and Asian markets from the part of the multinational companies. Country risk exposure became a concept more and more precious in terms of assessment and management. This paper aims at analyzing the way country risk exposure is incorporated into the equity cost of a company. The innovative element consists of underlying the differentiation between companies exposure to country risk. The country risk premium is not incorporated in a general manner, but in a very particular one, depending on the volume of operations that company develops within a country. The case study focuses on companies exposure to Romanian country risk. The research becomes more and more important as country risk can not be eliminated by diversification. Key-words: country risk, exposure, premium risk JEL Classification Numbers: G21, G30, G33 1. Introduction Emerging markets are an important source of growth for multinational companies which have already touched their maximum point of growth in the developed countries. But growth perspectives suppose also a high degree of risk since these markets are not considered to be stable. The unpredictability of the fiscal system as well as the instability of the political regime are considered to determine in an essential way the country risk which increase the company cost of equity. The financial contemporary literature has contained two essential questions lately: is it really necessary to compute a country risk premium. If so, should it be a general one, depending on every country, or should it be a particular one, adapted not only to every country, but to every company exposure to that country? The first question has been replied to in a unanimous way: yes, a risk premium must be estimated. The country risk is reflected by the premium risk which requires particular analysis, adapted to the level of a company exposure to a certain country. The dilemma is how to assess this risk premium having as point of reference two key-elements: the country risk and the company exposure. There is also another difficult element: this country risk can it be diversified or not? The answer is not a very categorical one since it can not be eliminated 100%. The remaining of this paper is structured as follows: the first section is dedicated to the risk premium assessment. The second section contains an analysis on the possibilities to eliminate or not the country risk by diversification. The third section implies an analysis on the company exposure to country risk. The fourth section includes a case study. The Romanian country risk premium will be computed as well as an IT company exposure to it. The fifth section includes the conclusions. 2. The country risk, can it be diversified? Stulz (1999) 1 made a research on country risk diversification and he pointed out that the key-element was represented by the marginal investor. If this marginal investor is globally diversified, global diversification is unlikely. An other key-element is represented by the differentiation between segmented market and open market. In a segmented market, risk premiums can be different in each one, because investors can not or will not invest outside their domestic market. In an open market, the marginal investor has the opportunity to invest across market. 1 See Stulz, R. M., Globalization, Corporate Finance and the Cost of Capital, Journal of Applied Corporate Finance, v12 150

2 Other analysts consider also that country risk implies a double side: one is represented by the non-systematic part which can be eliminated by diversification while the other is a systematic one, which implies the impossibility of diversification. This assumption subscribes to the idea that a certain percentage of the country risk will not be eliminated by any means. This theory is rooted into the concept of economical cycle correlation between the countries. Since there is a positive correlation between the economical cycles of the countries, investors will be unable to cut down the systematic part of the risk. Lately one has remarked that the positive correlation between the economical cycles has increased, which make impossible the elimination of the country risk. It can be reduced owing to diversification, which determines investors to concentrate on various countries, but it can be never eliminated to 100%. This idea increases the importance of the country risk assessment and measurement activity. 3. Company exposure to country risk Financial literature has lately agreed upon the fact that it is convenient to compute country risk exposure at the level of every company. ß approach implies that a company s exposure to country risk is proportional to its exposure to all other market risks. Thus, the cost of equity for a firm in an merging market can be written as follows: Cost of equity = Risk free Rate + ß (Mature Market Premium + Country Risk Premium) (1) where ß represents the specific volatility of every company. Companies with ß above one are considered to be very exposed to country risk while companies with ß below one are considered to be less exposed. The Lambda approach enables each company to have an exposure to country risk that is different from its exposure to all market risk. Like a Beta, a lambda will be scaled around 1, with a lambda of one indicating a company with average exposure to country risk and a lambda above or below 1 indicating above or below average exposure to country risk. The cost of equity for a firm in an emerging market can be written as: Expected return = Risk free rate + Beta (Mature Market Equity Risk Premium) + λ (Country Risk Premium) (2) The sensitivity of a company s stock price to country risk can be used in order to assess its lambda. Country risk is reflected by bonds. Investors anticipations are fundamental for bond price as they determine its raising if they are optimistic or its going down if they are pessimistic. A regression of the returns on a stock against the returns on a country bond should measure the lambda in the slope coefficient. 2 The limitation of this approach is that the country should have a liquid market of bonds in a very stable currency. In this case, analysts consider that the country risk premium is measured by the equity volatility which is reflected by the standard deviation in stock prices. It is considered that there is a direct proportionality between standard deviations and risk. Scaling the standard deviation of one market against another, a measure of relative risk is obtained: Relative Standard Deviation Country Risk = Standard Deviation Country X /Standard Deviation US (3) This relative standard deviation when multiplied by the premium used for US stocks should yield a measure of total risk premium for any market. Equity risk premium Country Risk = Risk Premium US *Relative Standard Deviation Country X (4) 2 See Damodaran, Aswath Measuring company exposure to country risk: theory and practice, Stern School of Business,

3 This methodology implies a risk when it comes about the emerging countries which have low standard deviations for their equity market because the markets are illiquid. In order to eliminate this hurdle, another methodology has been proposed, assuming that overall market is correctly priced: Value = Expected Dividends Next Period / (Required ROE Expected Growth Rate) (5) Three of the fourth inputs in this model can be obtained externally the current level of the market value, the expected dividend for the next period and the expected growth rate in earnings and dividends on long term. The required Return on Equity is the expected return on stocks. Substracting out the risk free rate will yield an implied equity risk premium. 4. Case study: Determining Romanian country risk Using the most frequent tool in order to compute country risk, meaning the bond spread default, Romania has a country risk of 1.21%. This country risk has been determined by the difference between the return on Romanian bonds issued in Euros and the return on EUR bonds. The point of reference for Romanian EUR bonds has been represented by the bonds issued Table 1 Romanian country premium risk ReturnsonRomanianandEUbonds 6,00 5,00 4,00 3,00 2,00 1,00 0, Series1 Romania and EU bonds (Source: Data processed by me) by OTP bank on the Luxembourg Stock Exchange in September 2006 on long term (10 years) with a return of The European bonds were considered to have an average return of 4.06%. The difference between the two variables has been interpreted as the Romanian country risk premium. The country risk premium can be measured also by the volatilities of the equity markets. A conventional indicator of equity risk is the standard deviation in stock prices. Higher standard deviations are generally associated with more risk. In this case, the relative standard deviation of Romanian equity market is computed as follows (taking as point of reference the evolution of BET reported to CAC 40 during the period ): Relative Standard Deviation Romanian equity market = 2029,943/ 69,64194 = 29,14828% (1) This relative standard deviation multiplied by the premium used for EU equity market should reflect a measure of the total risk premium of Romanian equity market. Equity risk premium Romanian country = 1.21% * 29,14828% = 35, % (2) The country risk premium can be highlighted as follows: Country Risk Premium Romania = 35, % - 5,25% = 0.3 (3) It is obvious that the country risk premium estimated by the two methodologies is quite different. The country risk premium estimated by the second methodology is lower than the previous one and this aspect has been determined by the fact that the Romanian stock market is less liquid than the others market and thus the volatility is very diminished. 152

4 The first result is more similar to the official assessment of Romania country risk delivered by the rating agencies (1.20%) 3. In comparison with other emerging countries such as Bulgaria, Czech Republic, Estonia, Hungary, Latvia or Lithuania, Romania has a medium country risk premium. Table 2 Romanian country premium risk 25 Bulgaria Romania Czech Republic Lithuania Estonia Latvia Slovakia Series1 5 0 Bulgaria Estonia Lithuania Slovakia (Source: Data processed by me) Supposing that we have to assess the exposure to Romania country risk of a company which develops its activity in the computer & software field. If we valorize the Beta approach, then its exposure in terms of cost of equity is: Cost of equity = ( ,21) = 14,29 (4) The Risk Free Rate has been considered the actual interest rate of European Central Bank while the mature market premium has been considered the return on European bonds. If the same company chose to develop its activity in Slovakia or in Bulgaria, then its exposure would be 13,97 and In this case, an investor would be very willing to choose Slovakia as investment target since it has the lowest country risk. 5. Conclusions The country risk premium is an essential variable when it comes about influencing the interest of the multinational companies for emerging countries. The challenges of the assessment process consist of choosing the proper methodology since the emerging countries imply some characteristic features in terms of macroeconomic analysis. 3 See s.com 4 The two exposures have been computed using the same Beta methodology and taking into account the two country ratings delivered by Moody s (1.05% for Slovakia and 2.03% for Bulgaria 153

5 References 1. Booth, L, Estimating the Equity Risk Premium and Equity Costs: New Way of Looking at Old Data, Journal of Applied Corporate Finance, v12 (1), 1999, Boucher M., Clark E., Groslambert B., Country Risk Assessment: A Guide to Global Investment Strategy, GMB Publishing, 2003, Chan, K.C., G.A. Karolyn and R.M. Stulz, Global Financial Markets and the Risk Premium on U.S. Equity, Journal of Financial Economics, v32, 1992, Damson, E., P. Marsh and M. Staunton, Triumph of the Optimists, Princeton University Press, Godfrey, S. and R. Espinosa, A Practical Approach to Calculating the Cost of Equity for Investments in Emerging Markets, Journal of Applied Corporate Finance, v9 (3), 1996, Hsu, Jason C., Jesus Saa-Requejo and Pedro Santa-Clara, Bond Pricing with Default Risk, Working Paper, UCLA, Ibbotson and Brinson, Global Investing, McGraw-Hill, New York, Indri, D.C. and W. Y. Lee,Biases in Arithmetic and Geometric Averages as Estimates of Long-run Expected Returns and Risk Premium, Financial Management, v26, 1997, Kealhofer, S., Bohn, J., Portfolio Management of Default Risk, Moody s KMV, San Francisco, Keenan, S., and J. Somewhat,,, Performance Measures for Credit Risks Models, Moody s Risk Management Services, Moody s KMV, Khandani, B., M. Lozano, and L. Carty,,,Moody s RiskCalc for Private Companies: The German Model, Moody s Investors Service Moody s KMV, Leland, Hayne E., Corporate Debt Value, Bond Covenants and Optimal Capital Structure, Journal of Finance, 49, 1994, Llewellyn H.,Handbook of Country And Political Risk Analysis, Political Risk Services, 2002, Stulz, R.M., Globalization, Corporate finance, and the Cost of Capital, Journal of Applied Corporate Finance, 2000, v12 154