Country Risk Premium
Country Risk Premium
The Capital Asset Pricing Model (CAPM) is one of the pillars of financial theory and widely used to calculate cost of equity in corporate valuation. The expected return in this model is composed out of two factors: the riskfree rate and the equity market risk premium times the firm specific beta factor. Recently a debate among scientists and practitioners has started whether and if so, how, country risk should be incorporated into the CAPM.
1. The trigger of the current debate: valuation of Austrian banks doing business in Eastern Europe
Current discussion around country risk premium (CRP) was triggered by a merger of two Austrian banks doing business in Eastern Europe, Raiffeisen International Bank-Holding AG and Cembra Beteiligungs AG. In the valuation report Damodaran's concept of country risk premia was used. When deriving the cost of equity for the banks, a CRP was added on top of the Austrian market risk premium to reflect the risk of less developed markets in Eastern Europe. In a first step, country specific premia were derived based on credit market spreads for the different countries (for details see section 2. below). The total CRP was calculated as weighted average over the different countries according to the banks' country exposures. For one bank, the CRP in the first year (4.53%) was almost as high as the Austrian MRP (4.75%) totaling to a risk premium of 9.28% in the first year. Finally cost of equity were derived by applying a beta estimate on the total RP and adding the result on the Austrian riskless rate. (see Deloitte Bericht Raiffeisen Strategieprojekt pp. 258, 261. http://www.ri.co.at/index.php?id=239, retrieved 22.9.2010)
2. What is country risk?
Country risk refers to the risk of investing in a country, dependent on changes in the business environment that may adversely affect operating profits or the value of assets in a specific country. For example, financial factors such as currency controls, devaluation or regulatory changes, or stability factors such as mass riots, civil war and other potential events contribute to companies' operational risks. This term is also sometimes referred to as political risk, however country risk is a more general term, which generally only refers to risks affecting all companies operating within a particular country. (see http://www.wikipedia.com/)
3. Country Risk Premium by Damodaran
Damodaran (1999 and 2003) discussed several questions concerning the CAPM in a globalized world and proposed to introduce a CRP into corporate valuation. He described the estimation of CRP to be sometimes chaotic due to illiquid emerging market and missing riskfree rate; and there are ample problems in calculating cost of capital of western firms already.
Starting point is the bond market spread in the country considered. Having the choice over corporate bond markets and government bonds Damodaran argues for country ratings and bond spreads as the basis for deriving the CRP. (This procedure was applied by in the valuation report of the case above). As one looks for the risk premium of the resp. equity market, an adjustment of the bond spread has to be made in order to reflect the higher risk. Damodaran proposes to use the ratio of the volatility of the returns in bonds and equity markets for this adjustment.
Finally there are some technical considerations how to add the premium derived into the equation for the cost of equity. Damodaran discusses three different versions of incorporating CRP into the cost of equity formula based on the CAPM:
(1) rj = rf + MRP x betaj + CRP
(2) rj = rf + MRP x betaj + CRP x lambda
(3) rj = rf + (MRP + CRP) x betaj
Note that the first two versions treat CRP as a separate risk factor and by doing so assume a multi-factor model for deriving the cost of equity. Model (3) is a single factor model and stays within the pure CAPM framework.
4. The critique by Kruschwitz/Löffler/Mandl (KLM)
In a recent working paper the three authors criticize Damodaran's concept. They argue that on a theoretical basis there is no justification for a CRP in an equilibrium model of the capital market. If one considers the CRP as an additional risk factor and assumes a multi factor model (as in the version (1) and (2) above), the authors refer to publications proving that multi-factor models in an equilibrium setting collide into the single factor model of the CAPM. Note that the standard critique on the CAPM by Fama/French is based on the empirical observation that the model is inable to fully explain the variation of stock returns by a single beta factor. Moving to version (3) above and staying within the single factor model of the CAPM the authors conclude based on a two country - model that neither in the case of different currencies nor in the case of a multi-national currency there is a theoretical justification for introducing a CRP into the CAPM equation for the cost of equity. The latter case deserves special interest at the background of the credit crisis of the PIGS countries within the monetary union: investors in those countries will use the bonds of those countries carrying the lowest risk within the union as rf; it is accessible without any additional fx-risk.
5. OutlookIt will be interesting to see how the discussion will evolve on academic level, e.g. by Damodaran publishing a paper or an article addressing the critique by KLM. For practical purposes an important question is whether despite the harsh critique Damodaran's concept will enter the German valuation scene as well: many German firms do business in countries exposed to risk factors covered by the concept.
Critique and literature on Country Risk Premium:
>more Kruschwitz, Löffler, and Mandl (2010) “Damodaran’s Country Risk Premium: A Serious Critique”; Working Paper
>more Damodaran, Aswath (2003) “Country risk and company exposure: theory and practice”, Journal of Applied Finance, 13, 64–78.
>more Damodaran, Aswath (2009) “Equity risk premiums (ERP): determinants, estimation and implications; a post-crisis update”, Financial Markets, Institutions and Instruments, 18, 289–370.
>more Cohen (2009) “Estimating the Equity Risk Premium for Economies in the Asian Region”, Asian Journal of Finance & Accounting
Links
>more Damodaran's Country Default Spreads and Risk Premiums
Additional information on CRP can be found on
http://en.wikipedia.org/wiki/Country_risk
http://www.oecd.org/document/49/0,2340,en_2649_34171_1901105_1_1_1_1,00.html
Find below some recent articles concerning equity risk premium and riskfree rate. Due to public overspending analysts are faced more than ever with the problem that there might be no riskfree rate anymore. Damodaran (2010) addresses the importance of the riskfree rate. He discusses the consequences of government defaults, by first noting the history and causes of such defaults. Different measures of sovereign or government default risk, ranging from sovereign ratings to credit default swaps to fundamental analysis are discussed, on the background of finding the best predictor of future default risk. On the other hand Black´s article from 1972 provided theoretical evidence that even in a world without a riskfree rate the CAPM is valid. All portfolios that are uncorrelated to the market portfolio have zero betas and no systematic risk. They all have the same expected return which can be used instead of the riskfree interest rate, thus still allowing to use the CAPM.
>more Damodaran (2010) “Into the Abyss: What If Nothing is Risk Free?”, Working Paper
>more Black (1972) “Capital market equilibrium with restricted borrowing”, Journal of Business, 45, 444-454
Corporate Governance
Current Status of Corporate Governance
The Financial Crisis revealed shortcomings in corporate governance. When needed, existing standards failed to provide checks and balances that companies need in order to cultivate sound business practices (OECD). The revised German Corporate Governance Code (GCGC) as amended on May 26, 2010 aims to improve the skill level of members in the supervisory board. It further calls for more women and internationals in both boards.
Changes:
The supervisory board has to be composed in such a way that it possesses the knowledge, ability, and expert experience required to properly complete its tasks. The members are responsible to get necessary training on their own and to take further education measures required for their tasks. In this concern they will be supported more by the company. The objectives of the supervisory board and the knowledge composition of its members as a group shall be published in the Corporate Governance Report.
When filling managerial positions in the firm the management board shall take diversity into consideration. Also an appropriate fraction of women in both management as well as supervisory board should be considered. Members of the management board of a listed company shall not accept more than a total of three supervisory board mandates in non-group listed companies or in supervisory bodies of companies with similar requirements. Firms must prove in the future whether they are able to take these steps to advance the boards quality.
The rules:
>more Government Commission GCGC Website
>more German Corporate Governance Code
>more Federal Ministry of Justice
Literature:
>more Kodex Report 2010
