Country and Political Risk

1
Country and Political Risk

• International Finance 250
• Dick Sweeney

2
Adjusting for Risk

• The standard NPV formula is
• NPV - CF0 ??t1 (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

3
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 mattersin CAPM,
  market-beta risk,
• ?Rm,Rproj ?Rm,Rproj (?Rproj / ?Rm)

4
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

5
Country Risk Premium

• Are you using CAPM?
• Then, RR rf ?Rm,Rproj (ERM - rf) no country
  risk premium, thats 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

6
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
  

7
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

8
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

9
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

10
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

11
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.)