International Value Creation

International Value CreationInternational Value Creation

Campbell R. HarveyDuke University

andNational Bureau of Economic Research

DRAFT

International ValueInternational Value1. Setting

• A critical component in implementing EVA in international context is knowing the appropriate hurdle rates.

• Each country has its own risk characteristics which need to be taken into account.


• Unfortunately, there is widespread disagreement over approaches to international valuation

• Different methods provide sharply different hurdle rates in international context


• Disagreement comes at a bad time with growth in global investment

International ValueInternational Value2. Goals

• Motivation

• Defining Country Risk

• Methods of Calculating Hurdle Rates

• Implementing the International Cost of Capital

• Country Risk and EVA

International ValueInternational Value3. Motivation

• Dramatic internationalization of world

– Economic integration through increased trade.

– Financial integration through liberalization of capital markets


0

0.5

1

1.5

2

2.5

3

Aus

tria

Bel

gium

Den

mar

k

Fra

nce

Ger

man

y

Ital

y

Can

ada

Fin

land

Irel

and

Aus

tral

ia

Hon

g K

ong

Uni

ted

Sta

tes

Uni

ted

Kin

gdom

Net

herl

ands

Nor

way

Sw

eden

Sw

itze

rlan

d

Japa

n

Spa

in

New

Zea

land

1966 1996

(Exports+Imports)/GDP Developed Countries


0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2

Gre

ece

Arg

enti

na

Bra

zil

Chi

le

Col

ombi

a

Mex

ico

Jord

an

Indi

a

Indo

nesi

a

Kor

ea

Mal

aysi

a

Por

tuga

l

Tur

key

Ven

ezue

la

Pak

ista

n

Phi

lippi

nes

Tha

iland

Nig

eria

Zim

babw

e

1966 1996

(Exports+Imports)/GDP Emerging Countries

International ValueInternational Value

3. Motivation

0

100

200

300

400

1982

1984

1986

1988

1990

1992

1994

1996

USD Billions

Value of US Acquisitions of Foreign Firms

0

20

40

60

80

1982

1984

1986

1988

1990

1992

1994

1996

Number of US Acquisitions of Foreign Firms

Number

Data through 1997.


3. Motivation

0

50

100

150

200

250

1982

1984

1986

1988

1990

1992

1994

1996

USD Billions

Value of Foreign Acquisitions of US Firms

0

20

40

60

80

1982

1984

1986

1988

1990

1992

1994

1996

Number of Foreign Acquisitions of US Firms

Number

Data through 1997.


3. Motivation

0

5

10

15

20

1982

1984

1986

1988

1990

1992

1994

1996

USD Billions

Value of German Acquisitions of US Firms

0

2

4

6

8

10

12

1982

1984

1986

1988

1990

1992

1994

1996

Number of German Acquisitions of US Firms

Number

Data through 1997.


3. Motivation

0

5

10

15

20

25

30

1982

1984

1986

1988

1990

1992

1994

1996

USD Billions

Value of US Acquisitions of German Firms

0

1

2

3

4

1982

1984

1986

1988

1990

1992

1994

1996

Number of US Acquisitions of German Firms

Number

Data through 1997.


4. Motivation Advantages• A broader selection of company targets• Access to growth and innovation in new markets• Lower operating costs

– Labor– Purchased materials

• Reduced taxes in selected markets• Reduced borrowing costs• Investment incentives• Reduced risk: Diversification among less correlated markets


4. Motivation Advantages

Diversification argument somewhat controversial

• Traditional view is that shareholders can do their own diversification.

• Modern view is that diversification reduces the volatility of a company’s cash flows and gives it the flexibility to pursue the most profitable projects–That is, if a company was not diversified, a negative current cash flow might exclude it from investing in high value projects (because the cost of debt and equity financing is high)

-0.10

0.10.20.30.40.50.60.70.80.9

AUSTRALIA

AUSTRIA

BELGIUM

CANADA

DENMARK

FINLAND

FRANCE

GERMANY

HONGKONG

IRELAND

ITALY

JAPAN

NETHERLND

NORWAY

NW Z

EALND

SINGAPORE

SPAIN

SWEDEN

SWIS

S

U.K.

USA

Averag

e

Since 1980 Since 1990


4. Motivation Correlations of World Returns and Developed Markets

Data through June 1998

-0.10

0.10.20.30.40.50.60.70.80.9

Argen

tina

Brazil

Chile

Colombia

Greece

India

Indones

ia

Jord

anKorea

Mala

ysia

Mex

ico

Nigeria

Pakist

an

Philippines

Portugal

Taiwan

Thailan

d

Turkey

Venez

uela

Zimbab

we

Average

Since 1980 Since 1990


4. Motivation Correlations of World Equity Returns and Emerging Markets

Data through June 1998

Disadvantages• Increased operating cost expectations

– Taxes, tariffs and quotas– Transportation/shipping costs– Infrastructure costs– Organizational costs

• Increased or different risk expectations– Lack of information– Different equity return premiums– Currency fluctuations– Liquidity risk– Sovereign risk (e.g. expropriation and restrictions on

repatriation of capital)


4. Motivation

0255075

100125150

Anam Electronics Korean Air Tongyang Moolsan


4. Motivation Investment of $100 in three Korean companies


5. Valuation Approaches Many common methods

Valuation Method Calculation Value TypeNet Tangible Assets V = Assets - Liabilities Break Up

Comparable Multiple- Price/Earnings- Market/Book- Price/Sales

V = P/E x EarningsV = M/B x BookV = P/Sales x Sales(Prices are current)

Current

Comparable Transaction - Premium to market - Premium to book - Acquisition multiple

V = Price/Book x BookV = Price/Market x MarketV = P/E x EarningsV = P/E x EarningsV = P/Sales x Sales(Prices from acquisitions)

Acquisition

DCF with Synergies V = CF (1+K)Cash flows include anticipated synergies and all real options

Acquisition


5. Valuation Approaches Ratios often not comparable across countries

Country Price-EarningsRatio

Price-to-BookRatio

DividendYield

USJapanUKGermanyFranceArgentinaBrazilMexicoKorea

27.22123.9619.4832.4828.9712.938.5712.74226.53

4.671.823.754.083.071.430.751.830.45

1.420.892.451.661.983.274.421.822.36

MSCI data as of June 1998

• DCF can be used to calculate business plan, capital investment, and acquisition values

• The same factors affect value around the globe– Cash flows– Timing– Risk


6. Global DCF Analysis

Value

– Liquidity– Repatriation

Limits

– Systematic– Currency– Information– Sovereign/

Credit Risk

– Currency Translation

– Accounting Adjustments

– Taxes

Cash Flow Timing Risk

Applying DCF to international opportunities requires adjustments to each component of value



Multistep process to apply DCF analysis to international opportunities

Determine “nominal” or

“real” forecast basis

Forecast local currency cash

flows

Adjust cash flows for specific risks

Translate into U.S. cash flows using forward

rates

Compute discount rate

adjust residual value, calculate

present value

Step 1 Step 2 Step 3 Step 4 Step 5



Calculate cash flows for international investment

Reflect systematic risks




flows

Adjust cash flows for risks


rates



present value




Unpredictable: Hyper-Inflationary

Economy

Predictable:Low to Moderate

Inflation Economy

Forecast “real” cash flows (backout or exclude

inflation)

Forecast “nominal” cash flows

(include inflation)

Discount cash flows with the “real”

economic valuation rate

Discount cash flows with the “nominal” economic

valuation rate






flows



rates



present value




Forecast cash flows in local currency

• Financial data is most often collected in local currency

• It has more relevance to the local management

• It facilitates reflecting local inflation in revenues and costs• It makes calculation of taxes, repatriation limits and currency

exposure easier• Conversion to US dollars is easier, simpler, and less prone to

error when done at the end of the local currency analysis• Works best in moderate to low inflation countries



When valuing global opportunities only include cash flows that can be remitted to the parent

• Governments sometimes set limits on cash out flows from their countries

– The amount of cash flow– The types of cash flows (e.g. dividends, profits and transfer costs)– When they can be taken out (e.g. none for five years)

• If repatriation is uncertain, estimate the probability of repatriation and calculate the expected value of future cash flows

• If delayed, cash flows should be included at the time they become available to shareholders

• However, if valuing for sale, include all cash flows, compute NPV, and then estimate what can be remitted






flows



rates



present value




Risk that a country's government might take actions that reduce the value of a firm to its current owners (e.g. expropriation, tax hikes)

Sovereign: country credit rating

CountrySystematic

Devaluation/ Revaluation

Risk that a drop in the value of a firm's currency will reduce the firm's value

CountrySystematic

Liquidity The risk that the owners might not be able to sell

assets when desiredSpecific

SpecificCurrency The risk that volatility in currency exchange rates causes a target's value to fluctuate

Inflation The risk that inflation will rise unexpectedly, reducing the present value of future international cash flows

Country Systematic

Interest Rate The risk that interest rates will rise unexpectedly,

reducing the present value of future international cash flows

CountrySystematic

Information The risk that limited or biased information might

lead you to over value a target companySpecific

International RisksRisk Description Risk Type Cash Flow Economic

Valuation Rate

Where to Reflect



International specific risks can be incorporated into expected cash flows using scenario analysis

Steps for Scenario Analysis

1 Identify risks and estimate their probabilities of occurrence

2 Estimate when they are most likely to occur

3 Identify the impact of each risk on expected cash flows

4 Calculate expected value of cash flows by weighting the cash flows in each scenario by the probability the scenario occurs

Note: The same should be done for NOPAT when calculating residual value using the perpetuity method



EXAMPLE

Incorporating information, currency transaction and liquidity risks into “Global-Co’s”cash flows forecast

Risks Estimated Probability Estimated Cash Flow Impact

Probability Adjustment

Estimated Timing

Currency Risk 100% -10% -10% Immediate

Information (i.e. market acceptance)

20% +5% 1% 2 years

Liquidity 5% -100% -5% 3 years

Risk Information

Sample Cash Flow Adjustment

Year 1 Year 2 Year 3 Year 4

Base Case Cash Flows$ Millions

$37 $50 $68 $83

Currency RiskInformationLiquidity

-10% 0% 0%

-10% 1% 0%

-10% 1% -5%

-10% 1% -5%

Total Adjustments -10% -9% -14% -14%

Adjusted Cash Flows ($M) $33 $46 $58 $72






flows



rates



present value




Future cash flows can be translated using exchange rate forecasts based on parity relationships

Example: Converting Forecast Peso Cash Flows into US$ Cash Flows

US$ Inflation* 1.4 1.4 1.4 1.4

Mexican Peso Inflation* 15.3 15.3 15.3 15.3

1 + i US$

1 + i Peso 0.8794 0.7733 0.6801 0.5981

Spot US$/Peso Rate 0.1177 0.1177 0.1177 0.1177

Forward US$/Peso Rate 0.1035 0.0910 0.0801 0.0704(Parity Factor x Spot Rate)

Peso Cash Flows 320 500 730 1020

US$ Cash Flows 33 46 58 72

*For calculation simplicity, same inflation rates were used each year

Year 1 Year 2 Year 3 Year 4

Parity Factor

=



When applied correctly, forecasting in US$ or local currency results in the same shareholder

value independent of the choice of currency

Assumptions:US Inflation Rate 1.4%Mexican Inflation Rate 15.3%US Cost of Capital 10.0%Mexican Cost of Capital 25.1%Spot Rate (US$/Peso) 0.1177

Cash Flows

Residual Value

Discount Factor

Present Value

Cumulative PV

Year1

Year2

Year3

Year4

320 500 730 1,020

4,067

0.7995 0.6392 0.5110 0.4086

256 320 373 2,078

Peso 3,027

Cash Flows

Residual Value

Discount Factor

Present Value

Cumulative PV

Year1

Year2

Year3

Year4

33 46 58 72

286

0.9091 0.8264 0.7513 0.6830

30 38 44 245

$356

Forward Rates 0.1035 0.0910 0.0801 0.0704

Peso Forecast US Dollar Forecast

Equivalent at 0.1177 US$/Peso spot exchange rate



Cumulative PV $556

Applying today’s spot rate to the forecast grosslyoverstates the value if projected local inflation exceeds US inflation -- in this example by 56%!

Assumptions:US Inflation Rate 1.4%Mexican Inflation Rate 15.3%US Cost of Capital 10.0%Mexican Cost of Capital 25.1%Spot Rate (US$/Peso) 0.1177

Cash Flows

Residual Value

Discount Factor

Present Value

Year1

Year2

Year3

Year4

38 59 86 120

478

34 49 65 409

Cash Flows

Residual Value

Discount Factor

Present Value

Year1

Year2

Year3

Year4

33 46 58 72

286

0.9091 0.8264 0.7513 0.6830

30 38 44 245

Forward Rates 0.1035 0.0910 0.0801 0.0704

US Dollar Forecast(incorrectly using Today’s Spot Rate)

US Dollar Forecast(using Forward Rates)

Spot Rate 0.1177 0.1177 0.1177 0.1177

0.9091 0.8264 0.7513 0.6830

Cumulative PV $356Cumulative PV $556 Cumulative PV $356



Forward Rates

Used to bring cash flows to U.S. dollars

Determined by differences in interest rates



Forward Rates

Covered Interest Rate Parity is enforced by arbitrage.



years t ofmaturity with yields bonddiscount pureYen andDollar ,

($/Y) rate exchangespot Current

future in the yearsin t delivery for ($/Y) rate exchange Forward

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tYt

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Forward Rates

Example.

Suppose a German 12-month T-bill yield is 8% and the U.S.12-month T-bill yield is 4%.

Does it make sense for the U.S. investor to invest in the higher yielding German T-bill?



Forward Rates

Answer: No

If you invest in the German T-bill, you will take on some currency risk. Suppose you invested 100m DM and at the end of the year you will receive 108m DM.

To hedge this risk, you will sell forward 108m DM today.

The forward rate will guarantee that you lock in a 4% return - which is no different than buying the U.S. T-bill!



Forward Rates

Rates are readily available for the major currencies from major banks and trading houses.

Example: Bloomberg screen for $/DM



Forward Rates

If no quoted forward rates:Use forward rate equation and interest rates to backout forward rates.

If no quoted interest rates:Use inflation forecasts and add real economic growth forecast tocreate nominal interest rates.






flows



rates



present value




Many different approaches:• Identical Cost of Capital (all locations)• World CAPM or Multifactor Model (Sharpe-Ross)• Segmented/Integrated (Bekaert-Harvey)• Bayesian (Ibbotson Associates)• Country Risk Rating (Erb-Harvey-Viskanta)• CAPM with Skewness (Harvey-Siddique)

International ValueInternational Value7. Economic Valuation Rate

• Goldman-integrated sovereign yield spread model• Goldman-segmented• Goldman-EHV hybrid• CSFB volatility ratio model• CSFB-EHV hybrid


Identical Cost of Capital

• Ignores the fact that shareholders require different expected returns for different risks


Identical Cost of Capital

• Risky investments get evaluated with too low of a discount rate (and look better than they should)

• Less risky investments get evaluated with too high of a discount rate (and look worse than they are)

• Hence, method destroys valueAvoid


World CAPM• Sharpe’s Capital Asset Pricing Model is the

mainstay of economic valuation• Simple formula• Intuition is that required rate of return depends on

how the investment contributes to the volatility of a well diversified portfolio


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• OK for developed markets if we allow risk to

change through time (Harvey 1991)


World CAPM

• Strong assumptions needed• Perfect market integration• Mean-Variance analysis implied by utility

assumptions• Fails in emerging markets


Returns and Beta from 1970

R2 = 0.013

-0.1

0

0.1

0.2

0.3

0.4

0.5

-0.5 0 0.5 1 1.5 2 2.5 3

Beta

Ave

rage

ret

urns

Should be a positive relation, with higher risk associated with higher return!But perhaps we should look at a more recent sample of data.


Returns and Beta from 1990

R2 = 0.0211

-0.1

0

0.1

0.2

0.3

0.4

0.5

-0.5 0 0.5 1 1.5 2 2.5 3

Beta

Ave

rage

ret

urns

Still goes the wrong way - even with data from 1990!


Returns and Beta from 1990 through 1998:03

R2 = 0.1064

-0.2

-0.1

0

0.1

0.2

0.3

0.4

-0.5 0 0.5 1 1.5 2

Beta

Ave

rage

ret

urns

Incorporating the Asian crisis makes the model look even worse.


World CAPM

• OK to use in developed markets• May give unreliable results in smaller, less liquid

developed markets


Segmented/Integrated CAPM

• CAPM assumes that markets are perfectly integrated– foreign investors can freely invest in the local market– local investors can freely invest outside the local market

• Many markets are not integrated so we need to modify the CAPM



• Bekaert and Harvey (1995)• If market integrated, world CAPM holds• If market segmented, local CAPM holds• If going through the process of integration, a

combination of two holds



Estimate world beta and expected return

= riskfree + w x world risk premium

Estimate local beta and expected return

= local riskfree + L x local risk premium



• Put everything in common currency terms• Add up the two components.

EVR= w[world EVR] + (1-w)[local EVR]• Weights, w, determined by variables that proxy

for degree of integration, like size of trade sector and equity market capitalization to GDP



• Weights are dynamic, as are the risk loadings and the risk premiums

• Downside: hard to implement; only appropriate for countries with equity markets

• Recommendation: Wait


Ibbotson Associates(Recognized expert in cost of capital calculation)

• Approach recognizes that the world CAPM is not the best model

• Ibbotson approach combines the CAPM’s prediction with naïve prediction based on past performance.


Ibbotson Associates• STEPS1 Calculate world risk premium=U.S. risk premium

divided by the beta versus the MSCI world (=7.8%)

2 Estimate country beta versus world index3 Multiply this beta times world risk premium


Ibbotson Associates

4 Add in 0.5 times the ‘intercept’ from the initial regression. “This additional premium represents the compensation an investor receives for taking on the considerable risks of the emerging markets that is not explained by beta alone.”


Ibbotson Associates

• Gives unreasonable results in some countries• Only useful if equity markets exist• Ibbotson Associates does not even use itRecommendation: Do not use this version.

Ibbotson is working on a better model to be available soon


CAPM with Skewness

• For years, economists did not understand why people spend money on lottery tickets and horse betting

• The expected return is negative and the volatility is high

• Behavioral explanations focused on “risk loving”


CAPM with Skewness

• But this is just preference for positive skewness (big positive outcomes)

• People like positive skewness and dislike negative skewness (downside)


CAPM with Skewness

• Most are willing to pay extra for an investment that adds positive skewness (lower hurdle rate), e.g. investing in China?


CAPM with Skewness

• Harvey and Siddique (1998) tests of a model that includes time-varying skewness risk

• Bekaert, Erb, Harvey and Viskanta detail the implications of skewness and kurtosis in emerging market stock selection


CAPM with Skewness

• Model still being developed• Skewness similar to many “real options” that are

important in project evaluationRecommendation: Wait


Goldman-Integrated

• This model is widely used by McKinsey, Salomon and many others.

• Addresses the problem that the CAPM gives a discount rate too low.

• Solution: Add the sovereign yield spread


Goldman-Integrated

• The sovereign yield spread is the yield on a U.S. dollar bond that a country offers versus a U.S. Treasury bond of the same maturity

• The spread is said to reflect “country risk”


Goldman-Integrated

STEPS• Estimate market beta on the S&P 500• Beta times historical US premium • Add sovereign yield spread plus the risk free


Goldman-Integrated-EHV Hybrid

• Goldman model only useful if you have sovereign yield spread

• Use Erb, Harvey and Viskanta model to fit ratings on yield spread


Real Yields and Institutional Investor Country Credit Ratings from 1990 through 1998:03

R2 = 0.8784

0.00%2.00%4.00%6.00%8.00%

10.00%12.00%14.00%

0 20 40 60 80 100

Rating

Rea

l Yie

lds



• You just need a credit rating (available for 136 countries now) and the EHV model will deliver the sovereign yield



• Even adding this yield spread delivers a cost of capital that is unreasonably low in many countries

• While you can get the yield spread in 136 countries with the EHV method, you can only get risk premiums for those countries with equity markets


Goldman-Segmented

• Main problem is the beta• It is too low for many risky markets• Solution: Increase the beta


Goldman-Segmented

• Modified beta=standard deviation of local market return in US dollars divided by standard deviation of the US market return

• Beta times historical US premium • Add sovereign yield spread


Goldman-Segmented

• Strange formulation. The usual beta is:

• Using volatility ratio implies that the Correlation=1 !!


World

iWorldiWorldi devStd

devStdnCorrelatioBeta

.

.,,

Goldman-Segmented

• No economic foundation for modification• No clear economic foundation for method in

generalRecommendation: Not recommended


CSFB

E[ri]=SYi + i{E[rus-RFus] x Ai} x Ki

• SYi = brady yield (use fitted from EHV)

i = the beta of a stock against a local index

Ai =the coefficient of variation (CV) in the local market divided by the CV of the U.S. market) where CV = /mean.


CSFB

• No economic foundation• Complicated, nonintuitive and ad hocRecommendation: Avoid


Country Risk Rating Model

• Erb, Harvey and Viskanta (1995)• Credit rating a good ex ante measure of risk• Impressive fit to data



• Erb, Harvey and Viskanta (1995)• Explore risk surrogates:

– Political Risk,

– Economic Risk,

– Financial Risk and

– Country Credit Ratings



Sources• Political Risk Services’ International Country Risk Guide

• Institutional Investor’s Country Credit Rating

• Euromoney’s Country Credit Rating

• Moody’s

• S&P



Political risk. International Country Risk Guide% of

Individual % ofPolitical Points Index CompositeEconomic expectations vs. reality 12 12% 6%Economic planning failures 12 12% 6%Political leadership 12 12% 6%External conflict 10 10% 5%Corruption in government 6 6% 3%Military in politics 6 6% 3%Organized religion in politics 6 6% 3%Law and order tradition 6 6% 3%Racial and nationality tensions 6 6% 3%Political terrorism 6 6% 3%Civil war 6 6% 3%Political party development 6 6% 3%Quality of the Bureaucracy 6 6% 3%

Total Political Points 100 100% 50%


Financial risk. International Country Risk Guide

FinancialLoan Default or unfavorable loan restructuring 10 20% 5%Delayed payment of suppliers’ credits 10 20% 5%Repudiation of contracts by governments 10 20% 5%Losses from exchange controls 10 20% 5%Expropriation of private investments 10 20% 5%

Total Financial Points 50 100% 25%


Economic risk. International Country Risk Guide

EconomicInflation 10 20% 5%Debt service as a % of exports of goods and services 10 20% 5%International liquidity ratios 5 10% 3%Foreign trade collection experience 5 10% 3%Current account balance as a % of goods and services 15 30% 8%Parallel foreign exchange rate market indicators 5 10% 3%

Total Economic Points 50 100% 25%

Overall Points 200 100%


International Country Risk Guide Risk Categories

Risk Category Composite Score Range

Very High Risk 0.0-49.5

High Risk 50.0-59.5Moderate Risk 60.0-69.5

Low Risk 70.0-84.5

Very Low Risk 85.0-100.0


Institutional Investor’s Country Credit Ratings

OECD Emerging Rest of World1979 1994 1979 1994 1979 1994

Economic Outlook 1 1 2 3 3 4Debt Service 5 2 1 1 1 1Financial Reserves/CurrentAccount

2 3 4 4 4 3

Fiscal Policy 9 4 9 7 6 6Political Outlook 3 5 3 2 2 2Access to Capital Markets 6 6 7 9 8 9Trade Balance 4 7 5 5 5 5Inflow of Portfolio Investment 7 8 8 8 7 8Foreign Direct Investment 8 9 6 6 9 7


Ratings are correlated:

0102030405060708090

100

Inst

itut

iona

l Inv

esto

r C

CR

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B

NR

S&P Sovereign Ratings



0102030405060708090

100

Eur

omon

ey C

CR

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B

NR




0102030405060708090

100

ICR

G C

ompo

site

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B

NR




Risk Measure ChangesII CCR ICRGC ICRGP ICRGF ICRGE

II CCR -0.03 0.01 0.03 -0.09ICRGC 0.35 0.79 0.54 0.43ICRGP 0.30 0.83 0.25 0.06ICRGF 0.26 0.60 0.35 0.05ICRGE 0.10 0.52 0.24 0.25

Risk Measure Levels


ICRG ratings predict changes in II ratings:

Attribute Coefficient T-Stat R-SquareICRGC 0.2120 7.59 5.0%ICRGP 0.1244 5.67 2.8%ICRGF 0.0956 5.69 2.8%ICRGE 0.0833 4.65 1.9%


Ratings predict inflation:

00.1

0.20.30.40.5

0.60.70.8

0.91

0 20 40 60 80 100

II Rating September 1996

Infl

atio

n ex

pect

atio

ns f

or 1

997


Ratings correlated with wealth:

$0

$5,000

$10,000

$15,000

$20,000

$25,000

0 20 40 60 80 100

II ratings for 74 countries

Per

cap

ita

real

GD

P


Time-series of ratings:

0102030405060708090

100

Switzerland Italy Kuwait Argentina

Returns and Institutional Investor Country Credit Ratings from 1990

R2 = 0.2976

-0.1

0

0.1

0.2

0.3

0.4

0.5

0 20 40 60 80 100

Rating

Ave

rage

ret

urns


Fit is as good as it gets - lower rating (higher risk) commands higherexpected returns. Even in among US firms, our best model gets about 30% explanatory power.

Returns and Institutional Investor Country Credit Ratings from 1990 through 1998:03

R2 = 0.0937

-0.2

-0.1

0

0.1

0.2

0.3

0.4

0 20 40 60 80 100

Rating

Ave

rage

ret

urns


Even with the turbulent Asian crisis returns, we still get an impressive fit.

Credit Rating Model

• Intuitive• Can be used in 136 countries, that is, in countries

without equity markets• Fits developed and emerging markets


Country Risk Rating ModelSTEPS:

EVR = risk free + 0.944 - 0.177 Log(IICCR)• Where Log(IICCR) is the natural logarithm of the

Institutional Investor Country Credit Rating



Easy to use:

0%

10%

20%

30%

40%

50%

60%

70%0 10 20 30 40 50 60 70 80 90 100

Rating

Hur

dle

rate

ICRGC IICCR:84 IICCR:79


Also predicts volatility:

R2 = 0.5033

0%

10%

20%

30%

40%

50%

60%

70%

0 20 40 60 80 100

Institutional Investor Country Credit Rating

An

nu

aliz

ed V

ola

tility


Fitted volatility:

0%

10%

20%

30%

40%

50%

60%

70%

80%

Rating

Exp

ecte

d vo

lati

lity

IICCR:84 IICCR:79


And correlation.

R2 = 0.6809

-20%

0%

20%

40%

60%

80%

100%

0 20 40 60 80 100

Institutional Investor Countyr Credit Rating

Co

rrela

tio

n w

ith

MS

CI

AC

Wo

rld


Fitted correlation.

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

Rating

Exp

ecte

d co

rrel

atio

n w

ith

wor

ld

IICCR:84 IICCR:79


Asian Crisis.

0102030405060708090

100

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

ICR

G r

atin

g

China Hong Kong India IndonesiaKorea Malaysia Pakistan PhilippinesSingapore Taiwan Thailand Russia


Asian Crisis.

60

65

70

75

80

85

90

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

Sep-9

8

ICR

G r

atin

g

Korea Malaysia Russia

Beginning of crisis


Value of US$100

020406080

100120140160180200

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

Sep-9

8

Val

ue o

f $1

00


Beginning of crisis


Value of local currency (indexed at 100)

0

20

40

60

80

100

120

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

Sep-9

8

Val

ue o

f $1

00


Beginning of crisis

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

Argentina Mexico Thailand

CAPMIbbotson EHVGS-EHVGS-SegCSFB-EHV

International ValueInternational Value8. Comparison of EVRs

68%

-20.00%-15.00%-10.00%

-5.00%0.00%5.00%

10.00%15.00%

20.00%25.00%30.00%

Slovakia Pakistan United States

CAPMIbbotson EHVGS-EHVGS-SegCSFB-EHV

537%


Estimated Equity Risk Premia:Country Risk Models

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

0 10 20 30 40 50 60 70 80 90 100

Country Risk Rating

Est

imate

d E

qu

ity R

isk

Prem

iaIICCR:1981IICCR:1985ICRGC:1985IICCR:1990ICRGC:1990

IICCR: Institutional Investor Country Credit RatingICRGC: International Country Risk Guide Composite RatingSee Table 2 for details.

Estimated Bond Risk Premia:Country Risk Models

-5%

0%

5%

10%

15%

20%

25%

30%

35%

0 10 20 30 40 50 60 70 80 90 100

Country RIsk Rating

Sp

rea

d o

ver U

S T

rea

sury IICCR

ICRGC

IICCR: Institutional Investor Country Credit RatingICRGC: International Country Risk Guide Composite RatingSee Table 2 for details.

Java Version


Excel version


International Value Creation

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