International Finance Risk Analysis and Project Evaluation Campbell R. Harvey Duke University, NBER and Investment Strategy Advisor, Man Group, plc February 1, 2017
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The Setting Prerequisite to any evaluation of a project is a keen knowledge of both the local and global environments Project evaluation requires skills in finance, economics, accounting, political science, psychology, sociology, and history. Local knowledge, while necessary, is not sufficient. The local environment is impacted by the global environment. 3
The Setting Global Macro Issues Shifting of risks from emerging to developed markets Potential slowing of growth in emerging markets Transition from partial integration to full Ugly contests in FX; challenges to fiat currency Trade wars (tariffs, non tariff barriers, border taxes, tax wars) Commodities and the environment 4
The Setting Wide variation in risk 5
Goal of Project Evaluation Do Benefits Outweigh the Costs? Expected cash flows need to be discounted to present value It is difficult to both forecast the cash flows and determine the appropriate discount rate Risk can be reflected in either the cash flows or the discount rate 6
Numerator and Denominator Do Benefits Outweigh the Costs? Simple example. If project risk free, suppose cash flows are 100 per year, forever, and risk free rate is 5%. The value is:. = 2,000 7
Numerator and Denominator Do Benefits Outweigh the Costs? Suppose the project is risky. Method 1 Adjust the Cash Flows:. = 1,000 8
Numerator and Denominator Do Benefits Outweigh the Costs? Suppose the project is risky. Method 2 Adjust the Discount Rate:. = 1,000 9
Goal of Project Evaluation Do Benefits Outweigh the Costs? Our goal is to come to an understanding at both a country and project level of how to adjust for risk It does not matter if we adjust the numerator or the denominator 10
Numerator and Denominator What is risk? There are many different views of risk. 11
Model 1: CAPM Key intuition If risk can be diversified, then it should not be rewarded. If it is rewarded, then there is an arbitrage possibility. Simple model measures risk as the sensitivity to returns on a globally diversified wealth portfolio. 12
Model 1: CAPM What are the sources of risk? Common (or systematic) risks. All projects are impacted to some degree by common risks. This impact is called the beta or exposure Idiosyncratic risk. These risk are specific to the project. 13
Model 1: CAPM 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 Works fine for developed markets if we allow risk to change through time (Harvey 1991) 14
Model 1: CAPM World CAPM Fails in most emerging markets Strong assumptions needed Perfect market integration Mean variance analysis implied by utility assumptions 15
Model 2: Sovereign Spread This model is widely used by consultants* Addresses the problem that the CAPM gives a discount rate too low. Solution: Add the sovereign yield spread which is the yield spread between a sovereign bond issued in US dollars against a similar maturity US Treasury bond Spread is a proxy for country risk *J.O. Mariscal and R. M. Lee, The valuation of Mexican Stocks: An extension of the capital asset pricing model to emerging markets, Goldman Sachs, June 18, 1993. 16
Model 2: Sovereign Spread Issues Ad hoc (no theory) and untested empirically Bolt on to a flawed CAPM May give unreasonably low cost of equity capital Any country risk premium reflected in a bond spread will not necessarily reflect the equity premium because bonds are less risky than equities 17
Model 2a: Adjusted Sovereign Spread Idea is to adjust the sovereign spread to make it more like an equity premium rather than a bond premium* A. Damodaran, Estimating equity risk premiums, working paper, NYU, undated. 18
Model 2a: Adjusted Sovereign Spread Damodaran Country Sovereign Equity std. dev. equity = yield x premium spread Bond std. dev. 19
Model 2a: Adjusted Sovereign Spread Damodaran Advantage: Recognizes that you just can t use the bond yield spread as a plug number in the CAPM Disadvantage: Sovereign spread contains more than country specific risk 20
Model 2a: Adjusted Sovereign Spread Issues: Since Damodaran s country risk premium can be neither theoretically nor empirically supported, the rates of return on capital that are derived by such methods are highly arbitrary. * *Kruschwitz, Loeffler and Mandl, 2010, Damodaran s Country Risk Premium: A Serious Critique. 21
Model 2a: Adjusted Sovereign Spread 2000 Sovereign spreads and measures of global risk 70 Note that US credit spreads are strongly correlated with sovereign spreads So sovereign spreads include more than country specific information 1800 1600 1400 1200 1000 800 600 400 200 U.S. High Yield Spread (bp) EMBI+ Composite Spread (bp) 60 50 40 30 20 10 0 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2007 2008 2009 2010 22
Model 3: Erb, Harvey, Viskanta Empirical model derived from correlating current country credit rating to future equity returns* Impressive fit to data (for both developed and emerging markets) *C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Journal of Portfolio Management, 1995. 23
Model 3: Erb, Harvey, Viskanta Just need a slope and an intercept Slope is negative 0.177 (lower rating means higher risk and higher discount rate) Average returns 0.5 0.4 0.3 0.2 0.1 0.0-0.1 Returns and Institutional Investor Country Credit Ratings from 1990 R 2 = 0.2976 0 20 40 60 80 100 Rating 24
Model 3: Erb, Harvey, Viskanta Formula: Discount Rate = risk free + intercept slope x Log(IICCR) Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating 25
Model 3: Erb, Harvey, Viskanta Model adopted by Duff & Phelps World s leading commercial experts on valuation 26
Model 3: Erb, Harvey, Viskanta 27
Model 3: Erb, Harvey, Viskanta Notice they implement with local currency returns 28
Model 3: Erb, Harvey, Viskanta 29
Model 3a: Adjusted Erb, Harvey, Viskanta Assume we exactly know the US equity risk premium Each quarter the Duke CFO survey asks senior US executives for their view of the 10 year equity risk premium Excess return forecast % 5 4 3 2 1 0 Figure 1a 10-year forecasted S&P 500 (mean) annual returns over and above the 10-year Treasury bond yield 30
Model 3a: Adjusted Erb, Harvey, Viskanta Assume we know the US equity risk premium Anchored model exactly delivers the known U.S. risk premium when we put the US country credit rating into the model Essentially, we are shifting the line to exactly match one data point that we know 31
Model 3a: Adjusted Erb, Harvey, Viskanta [Anchored] C13 = B9+100*(0.898 0.177*LN(B12)) ((B9+100*(0.898 0.177*LN(B11))) (B10+B9)) 32
Operating Risks: Country Specific Sovereign Risk (Macroeconomic) Exchange rate changes Currency convertibility and transferability Hyperinflation risk Sovereign Risk (Political/Legal) Expropriation Direct (seize assets) Diversion (seize project cash flows) Creeping (change taxation or royalty) Legal system May not be able to enforce property rights Sovereign Risk (Force Majeure) Political events Wars Labor strikes Terrorism Changes in laws Natural catastrophes Hurricanes/earthquakes /floods 33
Operating Risks: Country Specific Pre completion Resources available (quality/quantity) Technological risk (proven technology?) Timing risks (failure to meet milestones) Completion risk Post completion Market risks (prices of outputs) Supply/input risk (availability) Throughput risk (material put through plus efficacy of systems operations) Operating costs 34
Model 3a: Adjusted Erb, Harvey, Viskanta Method Use adjusted EHV model to get a baseline cost of equity capital for a project of average risk within a country Adjust key project specific risk exposures if the project s risks are different from the country average 35
Model 3a: Adjusted Erb, Harvey, Viskanta Project Risk Mitigation (-10 to 10; where 10=risk completely eliminated, 0=average for country) Impact on Country Weights Score Premium Sovereign 0.40 0.00 0.00 Currency (direct, e.g. convertibility) 0.10 0.00 0.00 Currency (indirect, e.g. political risk caused by crisis) 0.15 0.00 0.00 Expropriation (direct, diversion, creeping) 0.05 0.00 0.00 Commercial International partners 0.05 0.00 0.00 Involvement of Multilateral Agencies 0.05 0.00 0.00 Sensitivity of Project to wars, strikes, terrorism 0.05 0.00 0.00 Sensitivity of Project to natural disasters Operating 0.05 0.00 0.00 Resource risk 0.03 0.00 0.00 Technology risk Financial 0.05 0.00 0.00 Probability of Default 0.03 0.00 0.00 Political Risk Insurance 1.00 Sum of weights (make sure = 1.00) Project Cost of Capital 9.82 36
Conclusions There is no textbook agreement on how to measure the cost of equity capital in international markets EHV model is the only model that fits the data Nevertheless, best to look at a variety of estimates 37
The Instructor Campbell R. Harvey is the J. Paul Sticht Professor of International Business at the Fuqua School of Business, Duke University. He is also a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts. He served as 2016 President of the American Finance Association. Professor Harvey obtained his doctorate at the University of Chicago in business finance. His undergraduate studies in economics were conducted at the University of Toronto. He has served on the faculties of the Stockholm School of Economics, the Helsinki School of Economics, and the Graduate School of Business at the University of Chicago. He has also been a visiting scholar at the Board of Governors of the Federal Reserve System. He was recently awarded an honorary doctorate from Svenska Handelshögskolan in Helsinki. Harvey is an internationally recognized expert in portfolio management and global risk management. His work on the implications of changing risk and the dynamics of risk premiums for tactical asset allocation has been published in the top academic and practitioner journals. He has published over 125 scholarly articles and books. His work is frequently presented in international conferences and is often featured in the business press. In addition, Professor Harvey has wide ranging practical experience. He serves as Investment Strategy Advisor to the Man Group, the world s largest listed hedge fund group. Harvey served as Editor of the Journal of Finance which is the leading scientific publication inthefieldoffinanceandthe second highest rated journal in the economics profession between 2006 2012. Harvey has been awarded seven Graham and Dodd Awards/Scrolls for excellence in financial writing from the CFA Institute. Harvey is past winner of the Outstanding Faculty Award at the Fuqua School of Business, an annual award given by the students. 38