In this class, we will learn how to incorporate country risk in estimating the cost of equity for investments in emerging markets. 

The assignment contains a graded data exercise.

 

Powerpoint file:

country-risk1.ppt

 

Optional/background materials:

Country credit risk rating

International country risk guild (ICRG)

Cam Harvey's website

Emerging Markets Bonds

Introducing the J.P. Morgon Emerging Market Bond Index (EMBI)

(EMBI and EMBI+ are available from Bloomberg)

J.P. Morgan's Implied Default Probability Model

Moody's Sovereign Rating

S&P's Sovereign Rating

Bradynet.com

Emerging Markets Equity Index

EMDB: IFC/S&P Emerging Markets Data, which are installed on the workstations in the capital market room in the library.  Ask Frank Wilmot if you need assistance.

 

 

 

 

 

 

Assignment Sheet
Emerging Markets Finance
Darden Graduate School of Business
Spring First Half 2002

Class #6, Thursday, January 31, 2002

Topic: Incorporating country risk in valuation

Read:

Lessard, Donald R., 1996, “Incorporating Country Risk in the Valuation of Offshore Projects,” Journal of Applied Corporate Finance, 9 (Fall), pp. 52-63.

Godfrey, Stephen and Ramon Espinosa, 1996, “A Practical Approach to Calculating Costs of Equity for Investments in Emerging Markets,” Journal of Applied Corporate Finance, 9 (Fall), pp. 80-89.

Assignments:

A. Study questions:

  1. The first half of Lessard article gives a nice discussion and  summary of the risk management issues that we have discussed in the context of project finance in the first module. Review Lessard's taxonomy of risks.  (Note the typo in Figure 1.  Country-level price risks should be placed in the third place.)  In structuring a deal, how should you determine who should bears what risks?
  2. According to the two articles, how should you incorporate currency risk exposure in emerging markets in a capital budgeting model?  Do their advices differ?
  3. According to Lessard, how should you estimate the cost of equity for an investment project in an emerging market?  What are the key components?  Why should they be there?  And  how would you estimate them?
  4. What are the reasons for Godfrey and Espinosa to propose an adjustment factor of 60% to the country beta or the "adjusted country beta" that assumes the correlation coefficient between an emerging market country and the U.S. (or the world market) is equal to one? 

B. Data exercise (Graded.  Due in the beginning of the class.  You may email me your solution before the class or give me a hard copy in the beginning of the class). 

Data File: index-spread-A.xls

This file contains the S&P/IFCI total return indices for two emerging market countries (Argentina and Russia), the MSCI world total return index, and the two countries' sovereign spreads.  For more information on the data, see the coversheet in the data file.

Assignment

Some of the formulas needed to complete this assignment are summarized in the case:  country-beta.pdf

  1. Compute the monthly total returns on the Argentina country index, the Russia country index, and the MSCI world index.  Compute the average monthly returns and the standard deviation of the monthly returns for each of the indices.
  2. Estimate the country betas for Argentina and Russia.
  3. Using the Lessard formula, estimate the cost of equity for building a greenfield small aircraft engine plant in Argentina or in Russia. 
  4. Using the Godfrey-Espinosa formula, estimate the cost of equity for building a greenfield small aircraft engine plant in Argentina or in Russia. 
  5. What account for the difference in the cost of equity between Argentina and Russia?  Why?