Risk How to assess risk? Javier Estrada No universal agreement - PDF document

Emerging Markets (II): Risk Javier Estrada ADFIN – Winter/2014 1. Risk in EMs • Introductory issues • Wrong focus and implications • Political risk: Assessment and incorporation 2. Where to Account for Risk? • Possibilities • Simulations and implications Risk  How to assess risk? Javier Estrada  No universal agreement about it IESE Business • This is the case in developed markets (DMs) School Barcelona  And even more so in emerging markets (EMs) Spain  Still, risk‐based measures are essential for estimating discount rates, which in turn are essential for …  project evaluation  company valuation  performance evaluation  capital structure optimization  … ADFIN Winter/2014 1

Risk in EMs  Is there any consensus about risk in EMs? Javier Estrada  Only in that risk is ‘high’ (higher than in DMs) IESE Business  Two issues with this perception of ‘high’ risk School  Where does it come from? Barcelona Spain • Focus on …  individual countries (and stock‐market volatility)  political/country risk  Is it accurate? • If yes, adjust the required return accordingly • If not, overestimation of the required return  “ Unfortunately, the perception of elevated risk leads companies to reject good investment opportunities and to underestimate the performance of existing businesses .” (Goedhart & Haden, McKinsey) ADFIN Winter/2014 Focus on Individual EMs  A very volatile asset, with a low correlation to the Javier Estrada reference portfolio, is not necessarily risky IESE Business  In a properly‐diversified portfolio, a good part of School the risk is typically diversified away Barcelona Spain • Each EM may be individually volatile • But it may have a low correlation to other EMs in the portfolio • Then, the volatile EM may not be very risky from a portfolio perspective  Fact in EMs  The average stock‐market volatility is 37%  The volatility of a diversified index (EMI) is 24%  And, as Goedhart & Haden show … Go ADFIN Winter/2014 2

Focus on Political/Country Risk  Political risk is not an issue in DMs but it may be Javier Estrada an important component of risk in EMs IESE Business  Two important issues School • Should it be priced? Barcelona Go Spain  Is it diversifiable? (Is it correlated across EMs?)  Analogy to portfolio diversification • How to assess it? (How to quantify it?)  Many/varied ways, but no widely accepted one Go  When assessing political risk, keep in mind  Whether it should increase the required return • If so, avoid an arbitrary increase  Keep an eye on a possible over estimation • It leads to bypassing good investment opportunities ADFIN Winter/2014 Where to Account for Risk?  The NPV approach requires expected cash flows, Javier Estrada E(CFs), and a discount rate, DR IESE Business  Where should risk be accounted for? School Barcelona • By increasing the DR? Spain • By specifying ‘bad’ scenarios?  In practice, what companies do when adjusting the DR varies  Some use the same DR for all DMs and EMs  Some adjust the DR by the yield spread  Some arbitrarily adjust the DR by an arbitrary x % with respect to a similar project in DMs • 4‐5% is not an unusual number ADFIN Winter/2014 3

Where to Account for Risk?  In the CFs through scenario analysis (McKinsey) Javier Estrada  Theory suggests that only systematic risk should be IESE Business accounted for in the DR School  All other sources of risk should be accounted for in Barcelona Spain the CFs  In the DR (SalomonSmithBarney)  In principle scenario analysis is ideal  But it is nearly impossible to properly outline the scenarios, payoffs, and probabilities  In general, most corporations take into account the additional risk of EMs by adjusting the DR  But extreme caution is needed to avoid arbitrary increases in the DR ADFIN Winter/2014 Where to Account for Risk?  Consequences of arbitrary increases in the DR Javier Estrada (Goedhart & Haden, McKinsey) IESE Business  “ [Analysts & managers] grossly inflate assumptions School about the cost of capital – often pegging it at more Barcelona Spain than twice the level of similar projects in developed economies .”  “ Unfortunately, the perception of elevated risk leads companies to reject good investment opportunities and to underestimate the performance of existing businesses .”  Simulations  McKinsey / SalomonSmithBarney / Mine Go ADFIN Winter/2014 4

Appendix Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Focus on Individual EMs Javier Estrada “ While individual risks IESE in each country may Business School be high, it is important to keep in mind that Barcelona Spain they have low correlations with each other. As a result, the overall performance of an emerging ‐ market portfolio can be quite stable if investments are spread out over several countries .” (Goedhart & Haden, McKinsey) ADFIN Winter/2014 5

Focus on Individual EMs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Focus on Political/Country Risk Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 6

Political/Country Risk  Many possibilities exist to assess it Javier Estrada  Credit ratings (Standard & Poor’s, Moody’s, …) IESE Business  Country credit risk (CCR) index School Barcelona  Individual risk country guide (ICRG) index Spain  AON’s political risk map  Euromoney  Economist Intelligence Unit (EIU)  Control risk information services (CRIS)  Business environment risk intelligence (BERI)  Bank of America world information services  OECD’s country risk classification Go  … ADFIN Winter/2014 Credit Ratings (S&P, Moody’s, …)  Usually thought of as capturing political or, more Javier Estrada generally, country risk IESE Business  But they really aim to assess an issuer’s probability School of default Barcelona Spain  Key development: Re‐rating of EMs  Critical determinant of yield spreads  How much more an EM government pays, relative to the US (German) government … • to issue a bond in dollars (euros) • at the same maturity of the US (German) bond  These spreads are very volatile over time • Hence use extreme caution when projecting this figure forward, particularly if it is many years forward ADFIN Winter/2014 7

CCR Ratings  Country credit risk ratings … Javier Estrada  are published twice a year by Institutional Investor IESE Business  are based on surveys to banks School  scale from 0 (high risk) to 100 (low risk) Barcelona Spain  are arbitrarily weighted by banks’ sophistication  Factors  Economic outlook  Debt service  Financial reserves  Fiscal policy  Trade balance  Inflow of portfolio investment  Foreign direct investment ADFIN Winter/2014 ICRG Ratings  International country risk guide ratings … Javier Estrada  are published monthly by Political Risk Services IESE Business  are produced by PRS’ own analysts School  scale from 0 (high risk) to 100 (low risk) Barcelona Spain  Indexes  Economic (Objective): 25% weight  Financial (Objective + subjective): 25% weight  Political (Subjective): 50% weight  Composite ADFIN Winter/2014 8

ICRG Ratings Javier Political Economic Financial Estrada • Economic expectations • Inflation • Loan default or IESE versus reality • Debt service as a % of unfavorable loan Business • Economic planning exports of goods and restructuring School failures services • Delayed payment of Barcelona • Political leadership • International liquidity suppliers’ credit Spain • External conflict ratios • Repudiation of contracts • Corruption in • Foreign trade collection by governments government experience • Losses from exchange • Military in politics • Current account balance controls • Organized religion in as a % of goods and • Expropriation of private politics services investments • Law and order tradition • Parallel foreign exchange • Racial and national rate tensions • Political terrorism • Civil war • Political party development • Quality of the ADFIN bureaucracy Winter/2014 AON’s Political Risk Map Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 GoPdf Back 9

Where to Account for Risk? Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Where to Account for Risk? Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 GoXls 10