Screening Technique for International Investment in the Emerging Markets of the Telecommunication Industry - Research Proposal Example

The Screening Technique for International Investment in the Emerging Markets Specifically for Evaluating Business Case in the Telecommunication Industry CHAPTER I INTRODUCTION 1. Background According to modern portfolio theory, the two main motivating factors, which decide international investment in emerging nations, are risk and return (Stoica,2002). Based on the traditional views in the 1950s and the 1960s, home country investment had been considered to be the best option. Therefore, multinational investment was given only a secondary and risky position in these days (Buckley, 2003). Based on the modern theories, this viewpoint has changed. These theories clearly point out the advantages of multinational capital investment (Rugman, 1983) .Thus the modern viewpoint favours multinational capital investment than the home country investment. However, studies show that there are many opportunities and risk factors to be considered, before deciding to invest in a foreign country especially in an emerging market(Meldrum;2000;Nagy,1984;Hooper,1994;Lehman, 1999 etc).This will be in addition to the risk factors for home country investment. Hence, a study on developing the criteria for evaluating international investment in emerging markets has great relevance and policy implications. 2. Rationale for the Study Studies have shown that the traditional beta factor based on Capital Asset Pricing Models (CAPM) have failed to explain the risks for international investment in emerging nations (Estrada, 2000). This is because the international version of CAPM is based on implicit assumptions like perfectly integrated capital markets and sane returns for assets with same risks irrespective of their place of trading etc which do not hold good for the emerging markets(Harvey,1995;Bekaert,1995 etc). Several alternative methodologies like those based on risk factors have been developed for evaluating the attractiveness of international investment in emerging markets(Erb etal,1995;1996;Harvey,2005 etc).However, none of these have been able to provide a screening criteria at the company level in these countries. Hence, this study attempts to develop a methodology to evaluate the attractiveness of international investment in emerging nations at company level. The case study of telecommunications industry in emerging markets is done in this regard. 3. Scope of the Problem Emerging markets are found to be attractive destinations for international investment by many countries since they provide many opportunities like high returns, diminishing portfolio risk, many favourable political and economic factors conducive for foreign investment than the developing markets(Stoica, 2002). In addition to these, emerging markets also have political, economic and financial risks as well as specific risks like currency risks, sovereign risks etc associated with international investment. Hence, developing an appropriate methodology for evaluating the attractiveness of international investment has important policy implications. Moreover, telecommunication industry is now facing a downturn due to the global economic crisis, which demands the need for careful evaluations regarding investments in this industry (Sabbagh etal, 2009). This shows the relevance of the present study. 4. Research Questions and Objectives The research questions in the present study are how attractive is the international investment in emerging markets’ telecommunication industry? How related are the risk and returns in this case? For answering the above research questions, the objectives of the study are (1)to develop a specific methodology for evaluating the international investment in emerging markets’ telecommunication industry and (2) the empirical application of the methodology. The next chapter discusses the review of literature in this regard. CHAPTER II REVIEW OF LITERATURE 1. Introduction In this chapter, the available theoretical and empirical evidence on international investment in emerging nations are discussed. Section 2 critically reviews the theoretical evidence in this regard. Section 3 discusses the empirical studies in this regard and section 4 concludes the chapter. 2. Theoretical Review One of the most popular approach to evaluate the international investment has been the beta factor based on the CAPM by Sharpe (1964), Black (1970) etc. Based on this model, systematic risk called beta is defined as the contribution of the variance of a well diversified market portfolio (Harvey,2001). According to CAPM, for investing in a risky asset, an investor needs extra return to compensate for the underlying risk involved .This rate of return(Ke) is defined as the sum of risk free rate of return(Rf) and risk premium(Rm- Rf) multiplied by beta(KPMG,2005). Thus according to CAPM, Ke = Rf + β(Rm- Rf) ………(1), Similarly cost of debt is estimated as Kd = Rf + β(Rm- Rf)……..(2) Cost of capital is the sum total of cost of debt and cost of equity .One most popular approach to estimate the cost of capital based on the CAPM is to estimate the cost of capital as the weighted sum of cost of equity capital and cost of debt capital with the weights . According to the weighted average cost of capital approach(WACC), the cost of equity capital and cost of debt capital are weighted together to get the lowest possible cost of capital needed for the investor(Copenhagen economics,2008). There are many formulas for estimating the WACC. One formula for estimating the post tax WACC according to Copenhagen Economics(2008) is given as WACC = g*(1-T) *(Rf+ DRP) +(1-g) (Rf+ βj ERP) …..(3), where T is the company tax rate; DRP is the Debt Risk Premium, and ERP is the Equity Risk Premium and g is defined as g = Sum of debt/ (Sum of debt +Sum of equity) = D/(D+E). Many studies have criticized the use of beta as an appropriate risk of measure due to the failure of underlying assumptions for beta like no home bias, constant expected returns and risk and integration of market into world markets, for many equity markets(Erb etal, 1996;Harvey 2001 etc) . Moreover, the estimation of beta is sensitive to the period over which the estimates are averaged, the type of average used and the type of market portfolio. The alternative approach has been based on the country risk factors involved in international investment. The main risks to be considered in multinational capital investment can be classified as economic, financial, social, political and natural factors(Nagi,1984). The change in the economic structure or growth rate like fiscal changes, monetary changes and international changes are included in the economic risk factors. These are argued to cause significant change in the return of an investment. The changes in the currency exchange rate and government flexibility in allowing the firms to repatriate profits or funds outside the country are included in the financial risk factors. The instability and the political actions of government like attitude towards international investment are included in the political factors. These are supposed to affect the investment. Social and natural factors include risk arising from technological changes, environment changes etc (Meldrum, 2000). Given these theoretical approaches, the next section discusses the empirical studies in this regard. 3. Empirical Review Studies have shown that the CAPM has failed to explain the relationship between the risk and return in many emerging nations (Erb et al, 1996; Harvey 2001, 2005 etc). These studies obtained very low betas for emerging nations. Studies like Godfrey and Epsinosa(1995) adjusted CAPM by adding yield of an emerging market sovereign bond and yield of comparable US bond to risk free rate as well as adding adjustable beta for emerging nations. However, the adjustments in this study has been criticized as adhoc in other studies like Erb et al(1995). There have been many attempts for examining the country risks while conducting international investment. These country specific studies have been based on several methodologies. A four step process for analyzing country risk in the case of foreign direct investment by a multinational corporation is explained in the study by Bhall(1983). In this study, foreign investment risk management is defined as the process of evaluating the political stability and the market potential of a particular country by a multinational corporation. In this study, a two dimensional matrix is developed for analyzing country risk. This matrix called the foreign investment risk matrix consists of four variables for each dimension of political risk and economic risk. The study finds out income per capita and the distribution of income per capita as the main variables determining both economic and political risk. These two variables were obtained to reflect the underlying economy and the effectiveness of the political management. Moreover, income equality reduces both economic and political risk. Erby et al (1995, 1996) and Diamonte et al(1996) based on credit rating approach for countries obtained significant correlations between credit rating indices and stock returns as well as political credit ratings and stock returns respectively. The study by Madura (2000) uses Foreign Investment Risk Matrix for examining country risk factors. Here, it is presented in a continuous variable framework consisting of both economic risk ratings and political risk ratings. The risk is classified from low risk to high risk in this framework. Three categories are distinguished in this model. The countries that have acceptable risk levels, countries that have unacceptable risk levels, and countries with uncertain risk levels. It is recommended a more detailed analysis for countries in the uncertain area for an acceptable or unacceptable decision to be made. In the study by McGowan and Moeller (2003), the method of determination of empirical boundaries in the political risk and economic risk space is demonstrated. The variables per capita Gross National Income and the Index of Economic Freedom are used to classify countries as either acceptable for FDI, unacceptable for FDI, or uncertain for 128 countries. In the study by McGowan and Moeller (2005), a similar model with the same variables is developed with multinomial logistic regression. The problems with the country risk factor approach include subjectivity involved in the risk assessment and inability to apply these methods to company level. The time varying index of market integration by Bekaert and Harvey (1995), however, is very complicated in estimation procedures and hence are subject to errors. 4. Conclusion In this chapter, the various existing theoretical and empirical studies on the evaluation of international investment with special reference to emerging markets have been examined. It discusses the various risks involved in international investment more than the risks associated with home investment. The review shows that many traditional approached for evaluating international investment have not been applicable to emerging markets. The review also shows the need for developing a sound methodology for evaluating international investment at company level in the emerging markets. The next chapter discusses the methodology of the present study. CHAPTER III METHODOLOGY 1. Introduction In this chapter, the methodology for the present study is discussed. The next section discusses the methodology as well as the model, and the third section discusses the sample population. 2. Methodology of the Present Study In this study, a methodology based on modern portfolio theory developed by Estrada (2000) is used to evaluate the risk involved in international investment in telecommunication industry in the emerging markets. This methodology is selected here due to the following reasons. (1) Unlike other measures, this can be used at company level (2) no subjectivity involved (3) ability to capture the downside risk in the emerging markets. According to the above methodology, model for estimation is RRi = Rf + (RPW) (RMi)----------------------(1),where RRi is the required rate of return for telecommunication industry in emerging markets , Rf is the risk free rate, RPW is the world market risk premium, RMi is a risk measure and I denotes indices for markets. This is based on the assumption that the expected loss of purchasing power by the dollar needs to be compensated for the risk free rate. Based on a measure of downside risk, the semi standard deviation of returns is given by …………………(2), where ∑B is The semi deviation with respect to any benchmark return. 3. Sample Population The sample selected is monthly data for the period 2000 to 2008 for 28 emerging markets. Returns used are monthly returns for the telecommunication industry. Data source is Bloomberg. CHAPTER IV ANALYSIS, FINDINGS AND DISCUSSION 1. Introduction In this chapter, the analysis, findings and the interpretations of the findings are discussed. Section 2 discusses the data analysis and findings. Section 3 concludes the chapter. 2. Data Analysis and Findings The summary statistics for the data are given in table 1. The period of analysis is from 2000 to 2008. The results show high volatility, less correlation with international market while the returns from the telecommunications industry are not high as expected which can be due to the downturns in global financial crisis in 2008. Based on the low correlations with the world markets, it can be suggested that the markets in emerging nations are not fully integrated confirming the findings of previous studies .It also supports the findings of earlier studies that CAPM cannot be used for emerging markets. Moreover, the low correlation suggests significant portfolio diversification benefits from the emerging markets. The beta factor for most emerging markets are significantly higher than 1 in most cases which suggest that there has been considerable rise in these factors over the period of analysis. Moreover, the measure of skewness shows significant departure from symmetry .These two suggests the rise in risk factors for emerging markets in the recent years for telecommunication industry. Table1: Summary Statistics Market µA µG σ ρ β SSkw MCap Argentina 4.67 2.15 19.13 0.11 0.64 9.41 40.52 Brazil 5.29 1.61 18.17 0.3 1.59 * 2.03 120.22 Chile 1.06 1.76 7.88 0.25 0.53 * -0.55 30.37 China -0.87 -1.51 12.53 0.34 1.17 * 2.86 5.97 Colombia 0.54 0.12 8.36 0.19 0.47 1.58 6.47 Czech Rep. -0.1 -0.43 7.9 0.36 0.84 * -3.08 6.86 Egypt 1.47 1.19 7.87 0.09 0.2 4.54 6.56 Greece 2.22 1.62 11.75 0.25 0.76 * 8.54 33.59 Hungary 3.22 2.37 13.12 0.57 2.14 * 0.35 11.3 India 0.14 -0.18 8.17 0.21 0.46 1.7 50.47 Indonesia 1.57 0.28 17.34 0.2 0.93 * 10.42 9.78 Israel 0.38 0.16 6.63 0.46 0.84 * -1.08 28.9 Jordan 0.12 0.01 4.63 0.12 0.14 -0.88 2.15 Korea 0.67 -0.02 12.23 0.35 1.05 * 7.48 38.63 Malaysia 0.59 0.1 9.96 0.51 1.30 * 2.09 40.9 Mexico 2.55 1.95 10.81 0.4 1.13 * -2.33 90.4 Morocco 2.21 2.12 4.47 -0.37 -0.40 * 2.04 85.5 Pakistan -0.41 -1.12 11.84 0.12 0.34 0.5 2.01 Peru 1.25 0.68 10.76 0.44 1.40 * 0.42 9.27 Philippines 1.37 0.83 10.53 0.43 1.16 * 2.2 13.72 Poland 3.7 2.05 20.32 0.36 2.01 * 8.87 8.62 Russia 2.29 -0.85 24.58 0.49 3.64 * -0.05 33.77 South Africa 0.91 0.55 8.38 0.49 1.21 * -2.2 94.53 Sri Lanka 0.13 -0.33 9.55 0.37 1.02 * -0.56 1.61 Taiwan 1.51 0.72 12.74 0.28 0.93 * 2.01 140.32 Thailand 0.92 0.19 12.09 0.43 1.39 * 0.24 21.86 Turkey 2.14 0.68 17.74 0.1 0.55 4.18 20.12 Venezuela 1.57 0.26 15.67 0.26 1.29 * -1.62 9.85 Avgs. 1.4 0.61 11.97 0.29 1.03 2.11 30.76 EMF Index 1.29 1.05 6.89 0.59 1.02 * -3.9 671.81 Note: µA = Arithmetic Mean; µG = Geometric Mean; σ = Standard Deviation; ρ=correlation coefficient with respect to the world market; β=beta with respect to the world market; SSkw=Coefficient of standard skewness; MCap: Market cap of the MSCI index at year-end 2008 The correlations between the average monthly returns (MR) of the telecommunications industry and the risk variables are given in table 2. The risk measures considered are systematic risk(SR) measured by beta, total risk(TR) measured by the standard deviation of returns, idiosyncratic risk(IR) not explained by beta, size (Size)measured by logarithm of market capitalization and downside risk measured based on semi deviation of the returns with respect to mean of returns(∑µ) and risk free rate(∑f) respectively . Table 2: Correlation Matrix MR SR TR IR Size ∑µ ∑f MR 1 SR 0.34 1 TR 0.59 0.70 1 IR 0.48 0.61 0.99 1 Size 0.12 0.16 0.13 0.16 1 Σµ 0.47 0.77 0.98 0.98 0.19 1 Σf 0.28 0.77 0.91 0.93 0.18 0.99 1 The above table suggests significant correlations between total risk and idiosyncratic risk as well as idiosyncratic risk and downside risk with respect to mean returns respectively. This shows the importance of downside risk in explaining the relation between risk and return in emerging markets telecommunication industry. Table 3 shows the regression results for the monthly returns in the telecommunication industry and the different risk variables considered above. The model for estimation is MRi= γ0 + γ1RVi + µi, where MRi is the monthly return and RVi is the risk variable . Risk variable γ0 p-value γ1 p-value R2 Adj-R2 SR 0.86 0.03 0.53 0.09 0.11 0.07 TR -0.29 0.59 0.14 0.00 0.32 0.29 IR -0.12 0.83 0.14 0.01 0.24 0.21 Size 0.19 0.91 0.13 0.5 0.02 -0.02 Σµ -0.15 0.81 0.23 0.01 0.23 0.2 Σf 0.44 0.5 0.13 0.13 0.09 0.05 The above table shows that systematic risk is not significant in explaining the monthly returns. This can be due to the fact that this risk is based on the assumption of perfect integration of capital markets, which may not be realistic due to several barriers for the integration. At the same time, Total risk, idiosynchratic risk and downside risk with respect to mean are significant in explaining the monthly returns. Thus, the results show that risk measure based on CAPM are not significant in explaining the international investment in emerging markets in the case of telecommunication industry. 3. Conclusion In this chapter, the relationship between various risk measures and the monthly returns in the telecommunication industry are examined. The results show that downside risk plays a major role in explaining the relationship between risk and returns. Moreover, the results show that systematic risk based on CAPM is not significantly related with the returns while total risk, idiosynchratic risk and downside risk are significant in explaining the returns. CHAPTER V CONCLUSION Emerging markets have become the main destinations for international investment in the recent times due to the opportunities existing there for investment. In addition to these, there are certain specific risks inherent with these nations .This demands the need for developing a sound and concrete methodology for evaluating the attractiveness of international investment in emerging markets. This study makes an attempt in this regard taking the case of telecommunication industry in emerging markets. The traditional beta factor based on CAPM has failed to explain the risks involved with international investment in emerging markets as shown by the previous studies. The studies based on subjective country risk factors can be applied only at country level, while not at company level. Hence, in this study, the methodology developed by Estrado(2000) based on downside risk with respect to a benchmark return and several alternative risk variables has been selected to evaluate the attractiveness of international investment in telecommunication industry in the emerging markets. The analysis shows rising risks for these markets over the period of analysis. Moreover, the results indicate high volatility and less correlation of these markets with the world market. The results support the absence of perfect capital market integration in these nations. The correlation analysis shows that the relationship between risk and returns is better explained by downside risk. The regression analysis shows that systematic risk is not significant in explaining the monthly returns while idiosynchratic, total and downside risk are significant in explaining the monthly returns. The results thus support the findings of previous studies that beta factor based on CAPM cannot explain the risks involved with international investment in emerging markets. 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