Country Risk Premium - Essay Example

Country Risk Premiums al Affiliation There is often a great challenge in estimating the cost of capital in both developed and emerging markets. It is more vulnerable in the emerging markets since this is where investments are usually more risky as compared to the developed markets, though the amount of returns are always much higher. Based on this situation, the big question is on whether investments return in the emerging markets should either be rewarded through compensation in surplus of what is offered by an equal investment in the developed market (Baptista, 2003). Generally, a conclusion can be arrived at such that there is a wide acceptance that country risks needs to be put into consideration before making any sort of investments in emerging markets. The main argument in this paper is on the perspective that country risk and uncertainties is basically a non-diversifiable, as it is an integral aspect in the estimation models for the capital costs. INTRODUCTION There is general notion that risk is an essential element that should be taken into consideration in the course of any investment. The other fact is that the riskier the investment the higher the consequent returns as compared to the lower risk investments. The most needed investment return is often taken as the sum total of the risk premium and the risk-free rate. The ultimate end is usually an investor’s incentive for the sake of risk assumption. A higher reward should hence be provided by a riskier investment possibly in terms of risk premiums, so as to motivate the investor to assume the entire investment. The main debate that has often ensued in the academic literature is on the definition of risk, the risk measurement, as well as how the risk conversion should be measured in the expected investment returns for risk compensation. The risk models that are often utilized for corporate financial valuation, it is essential to undertake the ultimate estimation with regards to the risk and return premiums for the average investments termed as equity or market risk premium. It is hence vital for validating the Capital Assets Pricing Model, since it is currently considered as the most utilized both in practical and theoretical analysis. The research shows that; investors often have to make some cognitive strategies at the verge of investing in emerging countries. This is due to the fact that undertaking huge investments in emerging countries such as Latin America countries, Asia and South East Europe, among others is considered as being riskier than doing so in developed markets such as that of Japan, Western Europe and the USA (Berganza & García, 2004). Certainly, the investments returns are also a little bit lower in the developed markets as compared to that of the emerging markets. The estimates of the much needed return rates based on the developed markets scenario is mostly done with the Capital Assets Pricing Model. The practical weaknesses of this perspective are greatly recognized although there is a wide acceptance of its theoretical fundamentals. In the case of the emerging markets, it is often deemed as being more challenging to assess the return rates. The country risk should usually be rewarded with the country risk premium based on the required return rate with regards to an equivalent rate of investment in the developed countries. The primary objective of this paper is to provide a simple and clear analysis of the country risk premia, presentation of the most universal methodologies as well as giving out some insights on the significance of the country risk regarding to the investments surrounding the rising markets. It also sets basis on the fact that it should receive an entire reward with an adequate risk premium. The country risk element is often non-diversifiable thereby calling for the reward of a risk premium. ESTIMATION OF EQUITY COSTS IN EMERGING MARKETS In the process of evaluating acquisition of other foreign companies or dwelling on various investment projects multinational Companies should duly estimate both the projected cash flows and the most appropriate rates of discount that represents the capital cost. Undertaking an investment venture in the developing markets not only provides high returns, but on the other hand exposes the investors to a much higher risk. The big issue thus lies on the consequent approximates that poses extra costs in the form of possible risk premiums that investors need at the verge of investing in the developing markets (Canova, 1995) Capital investment estimates in an emerging market is a little bit different than it is in developed markets. The risk definition as well as the determination of factors influencing the equity return is more complicated in developed markets but also much more challenging in the emerging countries. The estimation equity costs the developed countries is mainly performed using the CAPM. The required return rates with accordance to this model can be given as the sum total of risk free rate and the market risk premium, whereby systematic risk happens to be the only risk that should be compensated since it embraces the common risk factors to the entire economy and thus cannot be spread in any possible manner. Based on this, the risk-free investments rate refers to the return rates that can be achieved through investment within a risk-free venture (Carlos, Chang, et.al., 2003). As much as all the investments are risky in nature, the issued government-based issued bonds of economically and politically stable countries are broadly considered as being free from the default risk. The risk premium often refers to the entire excess market returns over the rates involving the risk free perspective. Based on the CAPM there is existence of a linear relation between return and risks. This is to mean that, the security risk can be essentially compared with the market return and risk as well as the return rates that are often considered as being risk-free so as to properly compute the required security return rates and thus leading to a fairer price. The earlier development of CAPM led to a basic economic model whereby a simplified perception that was based on a number of assumptions was attained. Some of these basic aspects require an investor to be somehow rational. COUNTRY RISK DIVERSIFICATION As initially ascertained, investing in most of the emerging markets is deemed as being more risky as compared to the aspect of investing in the developed markets. The multinational firms that are often faced with a wide range of risks that are derived from aspects related to the specific foreign country, usually classified as economic, political and financial risk factors, it might seem unrealistic to duly invest abroad (Cuevas & International Monetary Fund, 2008). Most countries have since established what can be termed as the state-backed institution that are usually termed as the credit export agencies, so as to enhance the facilitation of the international trade as well as the promotion of exports. Their key task is the provision of the risk insurance to the subsequent companies as well as the exporters’ assistance through funding and financial support. Normally, the credit agencies might cover a wide range of expected risks that begins with the systematic default expense of an overseas client, such as the sovereign entities, and moves towards the aspect of hedging against the economic slowdown within a foreign market. These kinds of risks are normally categorized into the commercial risks at micro level and country risk just at what is considered as macro level. In line with this, there are other formal multilateral corporations that tend to offer global investors with insurance schemes for some of the non-commercial risks that are predominantly termed as the political risk elements insurance. Amongst them, the most essential has been the MIGA (Multilateral element of Investment Guarantee Authority) which is a specialized World Bank Group subsidiary (Engel & National Bureau of Economic Research, 1999). Most of such agencies often collaborate and share information within Investment Insurers and the International Credit Unions. Besides all these, there is a country risk form of insurance that is available to most of the multinational companies that tend to undertake foreign investments. The only key misunderstanding is on whether there must be extra country risk premiums for investments in the emerging countries. With accordance to CAPM, market risk happens to be the only practical and relevant risk. Therefore, there is usually no need of any extra risk premium especially if there is diversification of the country risk or the direct opposite. To diversify the country risks, the secondary investor should typically be diversified globally. In the other sense, markets can be mutually differentiated in one way or the other, either as being segmented or open markets, whereby the investors would not entirely invest abroad and on the other hand the risk premiums are somehow diverse in various markets. Open markets often refer to those markets whereby investors are in a position of investing outside the domestic and across various markets with the aim of achieving international diversification. Similarly, correlations seem to be much lower in a bull market rather than in a bear market. This research studies hence shows that the market correlations within the recent timeframe is indeed much higher hence reducing the rate of country risk diversification. On the other hand, there is also a clear confirmation that the investors within the developed markets can mutually diversify the country risk’s fluctuation, and hence it does not need any form of additional premium. The highly established markets are usually completely integrated with some of the international capital markets, but are not often the case in the emerging countries. This is because, it is a situation whereby markets are rarely in full integration and more so, investors are typically faced with some of the non-diversifiable risks. In such an amicable situation, the country risk has to be rewarded additionally with the prevailing country risk premium. There is hence clear evidence that a correlation exists between the expected returns and the country risk in the emerging market through the use of the implied equity cost that are usually based on the forecast market earnings. FACTORS THAT INFLUENCE COUNTRY RISK PREMIUMS To achieve the general country risk gain, a form of a weighting is assigned to 6 categories. The 3 major qualitative professional opinions refer to the political risk with a 30% weighting, the economic performance at (30%), as well as the structural assessment at (10%).  The 3 existing quantitative values are regarded as the debt indicators (10%), the credit evaluations (10%), and the accessibility to the capital markets/ bank finance (10%). The qualitative average on the other hand is produced through the combination of various evaluations regarding the political, structural and economic assessments from the experts across the globe. So, when applying for the economic, structural, and political assessments up to a 100% point scale, the following forms of weightings are employed:   economic 43%, structural 14%, and the political being at 43%. The U.S estimates and its relation with an emerging economy: The inquiry on the most appropriate time to backdate the analysis, the utilized risk free rate as well as how to compute the standard returns (geometric or arithmetic) might seem insignificant until a point whereby the overall impact of such choices on the risk premiums is witnessed. Instead of only relying on the temporarily analyzed values provided by the data services, the raw data based on the stocks, treasury bonds, and the treasury bills as from the year 1928 all the way to 2011 will be the most appropriate for making this kind of statistical analysis and compound assessment. These analyses have been summarized in table 1 as shown in the appendix segment. As much as the United States’ equities have worked towards delivery of higher returns as compared to the treasuries within this time period, they on the other hand have been very volatile. This allegation is largely evidenced by both the distributional extremes as well as the high returns with regards to the standard deviation. As indicated in the table below, the first shot can be mutually taken towards the perspective risk premium estimation through consideration of the difference between the average treasury returns and the average stock returns, thereby yielding a cognitive risk equity premium of around 7.54% for the stocks as compared to the T-bill that revolves between 11.20% & 3.66%, as well as an average percentage of almost 5.79 for the stocks when related to T.Bonds that lie between 11.20% & 5.41%. These values generally represent the long-term premiums and arithmetic averages for the stock’s relation with the treasuries. This is the basic reason why the estimation was under study was backdated up to the year 1928 so as to establish clear and more adequate approximations and analysis as indicated in the table below. The caveats concerning the reliability of data as well as the ever changing market features tend to apply into these kinds of estimates. A more troublesome feature of the historical risk premiums tend to exist. Through the final segment of 2007, the risk premium was at around 4.79%, which was elevated as compared to that of 2008 (3.88%). Addition of the 2008’s data, which is considered as an terrible year for the stocks but a good one for the bonds, tend to lower the rates of historical premiums even when subjected into a longer computation period. In effect, this approach can lead a number of investors made conclusions, after the worst stock and market predicament in various decades that the stocks risks were minimal as compared to the time-frame before the crisis and hence investors must therefore demand much lower equity premiums. In contrast, the addition of the 2009’s data, which was the best year for the stocks at around +25.94% but the worst one for bonds at around -11.12% percent would led to increase in the equity risk premium to 4.29% all the way from 3.88%. The main formula that is often used for calculation of the equity risk premiums is as shown below: With this formula, the Equity risk premiums for various countries with relation to that of the U.S. The case study here is that of Macedonia. The USA’s historical country risk premiums can be estimated at around 4.4%. It can hence be set as a risk premium benchmark in an established capital market structure. The yearly USA’s standard deviation regarding the stock and money market, as computed using the historical regular five year log returns as analyzed between September 2006 and August 2011, has been approximated to be at around 25.87%. On the other hand, the Macedonia’s standard deviation is taken to be at around 26.31%. Using the above formula, the Macedonia’s ERP can hence be computed as follows: As our good case study example, the Macedonia’s country risk premium can be extracted as follows: CRP R. Macedonia = 4.47 – 4.4 = 0.07 MEASURING COUNTRY RISK After the entire prove on the relevance of the country risk with regards to the investment capital cost estimation in emerging markets, the challenge hence emanates when it comes to the perspective of the country risk measurements as well as the conversion of such measures into relevant country risk premiums. There are 3 most utilized country risk measures that includes; the sovereign credit rates that are assigned by credit rating agencies, credit default swap spread, and the market-based measures. The analysis of these measures can be looked at as follows: The sovereign credit rates that are assigned by credit rating agencies: This refers to the country default risk measure and not significantly the perspective of equity risk. Considering that either of the risks is somehow influenced by equal factors including the budget, trade balance, currency stability, as well as the political stability, this kind of measure can hence be considered as an averagely correct country risk measure. This kind of measure is thus focused on the default risk perspective, and tends to ignore the other factors that can work towards influencing the equity market. This is essentially the primary problem that is correlated to this kind of measure (DArgensio & Laurin, 2008). Secondly, most of the rating agencies often lag behind a number of market movements hence failing to give a clear reflection on the immediate changes in the default risk factors. Thirdly, it has been also noted that the rating agencies are mainly focused on the default risks and hence this kind of menace can obscure some other risk factors that can still impact on the equity market. Fourthly, the utilized methodology by the rating agencies as well as the stages and particular considerations that are usually put into dire consideration while assigning the ratings of a country is not clearly disclosed. This hence tends to obscure the relative weight accorded to a particular variable that is utilized in each and every instance from observers. Thus, the sovereign credit rating decisions cannot be duly reliable (Fouejieu, Roger, et.al., 2013). Fifthly, the implied equity costs are often a discount rate that allows the sum total of the expected company cash flows to be equivalent to the prevailing stock price. Finally, the credit rating firms do not offer appropriate ratings for all the countries. Market based measures In contrast to the sovereign credit ratings, market-based measures that are usually allocated by the credit rating firms tend to reflect instantly on the market transformations with a wider scope. There is hence a meager proposal on the aspect of the country risk quantification all the way from the bond spread between the emerging market’s yield and maturity level, that is often under the denomination of either the euro or the US dollars as well as the entire yield of a duly comparable euro or USA bond, respectively. In addition, both securities should be granted in equal currency and should also have the same maturity levels. The sovereign bond spreads are largely considered as being the comprehensive and extensive measures of the general risk premiums with regards to a country; that stems from the market, credit, among other risks. The greatest challenge related to both measures has to do with the aspect of data extinction. This is to mean that, most emerging markets have not yet issued bonds that are denominated by Euros, dollars among other currencies that are inclined to the developed countries. Equity market volatility: This can also be considered as a good country risk measure. Emerging markets thus have got a higher volatility as compared to the developed markets. This perspective is technically correct, but a problem arises when it come the aspect of liquidity regarding the emerging markets. This is to mean that, market volatility is typically the ultimate function of the market liquidity. Illiquid and Risky markets often have lower levels of volatility. A single market can a little bit risky, but lower liquidity ratios at some point can be experienced, hence leading to understatement of volatility A general criticism has been made for all these country risk measures. There is an assumption that this country risk perspective is equivalent for all the organizations and projects. The fact is that; country risk has never been equal for all the existing firms and projects (Naumovski, 2012). Some economic segments can pose lesser risk than others, while some other project segments might not be subjected to any form of risk at all. References Baptista, J. E. Y. (2003). Risk premium on sovereign bonds and budgetary discretion vs. rules for a developing country: The case of Brazil. São Paulo, Brazil: Escola de Administração de Empresas de São Paulo, Fundação Getulio Vargas, Núcleo de Pesquisas e Publicações. Berganza, J. C., & García, H. A. (2004). What makes balance sheet effects detrimental for the country risk premium?. Madrid: Banco de España. Canova, F., De, N. G., & Centre for Economic Policy Research (Great Britain). (1995). The equity premium and the risk free rate: A cross country, cross maturity examination. London: Centre for Economic Policy Research. Carlos, B. J., Chang, R., García, H. A., & Banco de España. (2003). Balance sheet effects and the country risk premium: An empirical investigation. Spain: Banco de España. Cuevas, A., & International Monetary Fund. (2008). Pension privatization and country risk. Washington, D.C: International Monetary Fund. DArgensio, J.-J., & Laurin, F. (2008). The real estate risk premium: A developed/emerging country panel data analysis. Louvain-la-Neuve: CORE. Engel, C., & National Bureau of Economic Research. (1999). On the foreign exchange risk premium in sticky-price general equilibrium models. Cambridge, MA: National Bureau of Economic Research. Fouejieu, A. A., Roger, S., & International Monetary Fund. (2013). Inflation targeting and country risk. Washington, D.C.: International Monetary Fund. Naumovski, A. (January 01, 2012). Estimating the country risk premium in emerging markets: the case of the Republic of Macedonia. Financial Theory and Practice, 36, 4, 413-434. Yu, B.-K. (2008). The country and exchange risk premium with the Euro Area and the U.S. based on price parity models Appendix Figure 1: Figure 2: Read More