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Whydoriskfreeratesvaryacrosscurrencies?January2016Riskfreerates

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-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%JapaneseYen

CzechKo

runa

SwissFranc

Taiwanese$

BulgarianLev

Euro

Hun

garianForin

t

ThaiBaht

DanishKron

e

SwedishKron

a

HK$

CroatianKu

na

IsraeliShekel

RomanianLeu

Canadian$

NorwegianKron

e

BritishPou

nd

KoreanW

on

PakistaniRup

ee

PhillipinePeso

PolishZloty

VietnameseDon

g

ChineseYuan

US$

Singapore$

MalyasianRinggit

Australian$

NZ$

IcelandKron

a

ChileanPeso

MexicanPeso

IndianRup

ee

PeruvianSol

ColombianPeso

Indo

nesianRup

iah

VenezuelanBolivar

RussianRu

ble

NigerianNaira

TurkishLira

SouthAfricanRand

KenyanShilling

BrazilianReai

RiskfreeRates- January2016

RiskfreeRate DefaultSpreadbasedonrating

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RiskfreeRate:Don’thaveortrustthegovernmentbondrate?1. Buildupapproach:Theriskfreerateinanycurrencycanbe

writtenasthesumoftwovariables:Riskfreerate=ExpectedInflationincurrency+Expectedrealinterestrate

Theexpectedrealinterestratecanbecomputedinoneoftwoways:fromtheUSTIPsrateorsetequaltorealgrowthintheeconomy.Thus,iftheexpectedinflationrateinacountryisexpectedtobe15%andtheTIPsrateis1%,theriskfreerateis16%.

2. US$Rate&DifferentialInflation:Alternatively,youcanscaleuptheUS$riskfreeratebythedifferentialinflationbetweentheUS$andthecurrencyinquestion:

RiskfreerateCurrency=

Thus,iftheUS$riskfreerateis2.00%,theinflationrateintheforeigncurrencyis15%andtheinflationrateinUS$is1.5%,theforeigncurrencyriskfreerateisasfollows:Riskfreerate= 1.02 !.!"

!.!"# − 1=15.57%

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Onemoretestonriskfreerates…

¨ OnJanuary1,2016,the10-yeartreasurybondrateintheUnitedStateswas2.27%,ahistoriclow.AssumethatyouwerevaluingacompanyinUSdollarsthen,butwerewaryabouttheriskfreeratebeingtoolow.Whichofthefollowingshouldyoudo?a. Replacethecurrent10-yearbondratewithamorereasonable

normalizedriskfreerate(theaverage10-yearbondrateoverthelast30yearshasbeenabout5-6%)

b. Usethecurrent10-yearbondrateasyourriskfreeratebutmakesurethatyourotherassumptions(aboutgrowthandinflation)areconsistentwiththeriskfreerate

c. Somethingelse…

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Someperspectiveonriskfreerates

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Interestratefundamentals:T.Bondrates,Realgrowthandinflation

Inflationrate RealGDPgrowth Ten-yearT.Bondrate

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NegativeInterestRates?

¨ In2016,therewereatleastthreecurrencies(SwissFranc,JapaneseYen,Euro)withnegativeinterestrates.Usingthefundamentals(inflationandrealgrowth)approach,howwouldyouexplainnegativeinterestrates?

¨ Hownegativecanratesget?(Isthereabound?)¨ Wouldyouusethesenegativeinterestratesasriskfreerates?¤ Ifno,whynotandwhatwouldyoudoinstead?¤ Ifyes,whatelsewouldyouhavetodoinyourvaluationtobeinternallyconsistent?

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TheEquityRiskPremium

DiscountRates:II44

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Theubiquitoushistoricalriskpremium

¨ Thehistoricalpremiumisthepremiumthatstockshavehistoricallyearnedoverrisklesssecurities.

¨ Whiletheusersofhistoricalriskpremiumsactasifitisafact(ratherthananestimate),itissensitiveto¤ Howfarbackyougoinhistory…¤ WhetheryouuseT.billratesorT.Bondrates¤ Whetheryouusegeometricorarithmeticaverages.

¨ Forinstance,lookingattheUS:

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Theperilsoftrustingthepast…….

¨ Noisyestimates:Evenwithlongtimeperiodsofhistory,theriskpremiumthatyouderivewillhavesubstantialstandarderror.Forinstance,ifyougobackto1928(about80yearsofhistory)andyouassumeastandarddeviationof20%inannualstockreturns,youarriveatastandarderrorofgreaterthan2%:

StandardErrorinPremium=20%/√80=2.26%¨ SurvivorshipBias:UsinghistoricaldatafromtheU.S.equitymarketsoverthetwentiethcenturydoescreateasamplingbias.Afterall,theUSeconomyandequitymarketswereamongthemostsuccessfuloftheglobaleconomiesthatyoucouldhaveinvestedinearlyinthecentury.

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RiskPremiumforaMatureMarket?Broadeningthesampleto1900-2015

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Country GeometricERP ArithmeticERP StandardErrorAustralia 5.00% 6.60% 1.70%Austria 2.60% 21.50% 14.30%Belgium 2.40% 4.50% 2.00%Canada 3.30% 4.90% 1.70%Denmark 2.30% 3.80% 1.70%Finland 5.20% 8.80% 2.80%France 3.00% 5.40% 2.10%Germany 5.10% 9.10% 2.70%Ireland 2.80% 4.80% 1.80%Italy 3.10% 6.50% 2.70%Japan 5.10% 9.10% 3.00%Netherlands 3.30% 5.60% 2.10%New Zealand 4.00% 5.50% 1.70%Norway 2.30% 5.20% 2.60%South Africa 5.40% 7.20% 1.80%Spain 1.80% 3.80% 1.90%Sweden 3.10% 5.40% 2.00%Switzerland 2.10% 3.60% 1.60%U.K. 3.60% 5.00% 1.60%U.S. 4.30% 6.40% 1.90%Europe 3.20% 4.50% 1.50%World-ex U.S. 2.80% 3.90% 1.40%World 3.20% 4.40% 1.40%

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Thesimplestwayofestimatinganadditionalcountryriskpremium:Thecountrydefaultspread

¨ Defaultspreadforcountry:Inthisapproach,thecountryequityriskpremiumissetequaltothedefaultspreadforthecountry,estimatedinoneofthreeways:¤ Thedefaultspreadonadollardenominatedbondissuedbythecountry.

(InJanuary2016,thatspreadwas4.83%fortheBrazilian$bond)¤ ThesovereignCDSspreadforthecountry.InJanuary2016,thetenyear

CDSspreadforBrazil,adjustedfortheUSCDS,was5.19%.¤ Thedefaultspreadbasedonthelocalcurrencyratingforthecountry.

Brazil’ssovereignlocalcurrencyratingisBaa3andthedefaultspreadforaBaa3ratedsovereignwasabout2.44%inJanuary2016.

¨ Addthedefaultspreadtoa“mature”marketpremium:ThisdefaultspreadisaddedontothematuremarketpremiumtoarriveatthetotalequityriskpremiumforBrazil,assumingamaturemarketpremiumof6.00%.¤ CountryRiskPremiumforBrazil=2.44%¤ TotalERPforBrazil=6.00%+2.44%=8.44%

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AnequityvolatilitybasedapproachtoestimatingthecountrytotalERP

¨ Thisapproachdrawsonthestandarddeviationoftwoequitymarkets,theemergingmarketinquestionandabasemarket(usuallytheUS).Thetotalequityriskpremiumfortheemergingmarketisthenwrittenas:¤ Totalequityriskpremium=RiskPremiumUS*sCountry Equity/sUS Equity

¨ ThecountryequityriskpremiumisbaseduponthevolatilityofthemarketinquestionrelativetoU.Smarket.¤ AssumethattheequityriskpremiumfortheUSis6.00%.¤ AssumethatthestandarddeviationintheBovespa (Brazilianequity)is

30%andthatthestandarddeviationfortheS&P500(USequity)is18%.

¤ TotalEquityRiskPremiumforBrazil=6.00%(30%/18%)=10.0%¤ CountryequityriskpremiumforBrazil=10.00%- 6.00%=4.00%

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Ameldedapproachtoestimatingtheadditionalcountryriskpremium

¨ Countryratingsmeasuredefaultrisk.Whiledefaultriskpremiumsandequityriskpremiumsarehighlycorrelated,onewouldexpectequityspreadstobehigherthandebtspreads.

¨ Anotheristomultiplythebonddefaultspreadbytherelativevolatilityofstockandbondpricesinthatmarket.UsingthisapproachforBrazilinJanuary2016,youwouldget:¤ CountryEquityriskpremium=Defaultspreadoncountrybond*sCountry

Equity /sCountry Bondn StandardDeviationinBovespa (Equity)=30%n StandardDeviationinBrazilgovernmentbond=20%n DefaultspreadforBrazil=2.44%

¤ BrazilCountryRiskPremium=2.44%(30%/20%)=3.66%¤ BrazilTotalERP=MatureMarketPremium+CRP=6.00%+3.66%=9.66%

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ATemplateforCountryRisk

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Black #: Total ERPRed #: Country risk premiumAVG: GDP weighted average

ERP

: Jan

201

6

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FromCountryEquityRiskPremiumstoCorporateEquityRiskpremiums

¨ Approach1:Assumethateverycompanyinthecountryisequallyexposedtocountryrisk.Inthiscase,¤ E(Return)=RiskfreeRate+CRP+Beta(MatureERP)¤ Implicitly,thisiswhatyouareassumingwhenyouusethelocalGovernment’s

dollarborrowingrateasyourriskfreerate.¨ Approach2:Assumethatacompany’sexposuretocountryriskissimilar

toitsexposuretoothermarketrisk.¤ E(Return)=RiskfreeRate+Beta(MatureERP+CRP)

¨ Approach3:Treatcountryriskasaseparateriskfactorandallowfirmstohavedifferentexposurestocountryrisk(perhapsbasedupontheproportionoftheirrevenuescomefromnon-domesticsales)¤ E(Return)=RiskfreeRate+b (MatureERP)+l (CRP)

MatureERP=MaturemarketEquityRiskPremiumCRP=Additionalcountryriskpremium

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Approaches1&2:Estimatingcountryriskpremiumexposure

¨ LocationbasedCRP:Thestandardapproachinvaluationistoattachacountryriskpremiumtoacompanybaseduponitscountryofincorporation.Thus,ifyouareanIndiancompany,youareassumedtobeexposedtotheIndiancountryriskpremium.Adevelopedmarketcompanyisassumedtobeunexposedtoemergingmarketrisk.

¨ Operation-basedCRP:Thereisamorereasonablemodifiedversion.Thecountryriskpremiumforacompanycanbecomputedasaweightedaverageofthecountryriskpremiumsofthecountriesthatitdoesbusinessin,withtheweightsbaseduponrevenuesoroperatingincome.Ifacompanyisexposedtoriskindozensofcountries,youcantakeaweightedaverageoftheriskpremiumsbyregion.

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OperationbasedCRP:SingleversusMultipleEmergingMarkets

¨ Singleemergingmarket:Embraer,in2004,reportedthatitderived3%ofitsrevenuesinBrazilandthebalancefrommaturemarkets.ThematuremarketERPin2004was5%andBrazil’sCRPwas7.89%.

¨ Multipleemergingmarkets:Ambev,theBrazilian-basedbeveragecompany,reportedrevenuesfromthefollowingcountriesduring2011.

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Extendingtoamultinational:RegionalbreakdownCocaCola’srevenuebreakdownandERPin2012

Things to watch out for1. Aggregation across regions. For instance, the Pacific region often includes Australia & NZ with Asia2. Obscure aggregations including Eurasia and Oceania

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