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

▶
risk
SMART_READER_LITE
LIVE PREVIEW

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

Sep 25, 2022 527 likes •641 views

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

slide-1
SLIDE 1

1

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

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Risk

  • How to assess risk?
  • No universal agreement about it
  • This is the case in developed markets (DMs)

 And even more so in emerging markets (EMs)

  • 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
  • …
slide-2
SLIDE 2

2

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Risk in EMs

  • Is there any consensus about risk in EMs?
  • Only in that risk is ‘high’ (higher than in DMs)
  • Two issues with this perception of ‘high’ risk
  • Where does it come from?
  • 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)

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Focus on Individual EMs

  • A very volatile asset, with a low correlation to the

reference portfolio, is not necessarily risky

  • In a properly‐diversified portfolio, a good part of

the risk is typically diversified away

  • 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

slide-3
SLIDE 3

3

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Focus on Political/Country Risk

  • Political risk is not an issue in DMs but it may be

an important component of risk in EMs

  • Two important issues
  • Should it be priced?

Go

 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 overestimation
  • It leads to bypassing good investment opportunities

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Where to Account for Risk?

  • The NPV approach requires expected cash flows,

E(CFs), and a discount rate, DR

  • Where should risk be accounted for?
  • By increasing the DR?
  • 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
slide-4
SLIDE 4

4

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Where to Account for Risk?

  • In the CFs through scenario analysis (McKinsey)
  • Theory suggests that only systematic risk should be

accounted for in the DR

  • All other sources of risk should be accounted for in

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

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Where to Account for Risk?

  • Consequences of arbitrary increases in the DR

(Goedhart & Haden, McKinsey)

  • “[Analysts & managers] grossly inflate assumptions

about the cost of capital – often pegging it at more 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

slide-5
SLIDE 5

5

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Appendix

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Focus on Individual EMs

“While individual risks in each country may be high, it is important to keep in mind that they have low correlations with each

  • ther. As a result, the
  • verall performance of

an emerging‐market portfolio can be quite stable if investments are spread out over several countries.” (Goedhart & Haden, McKinsey)

slide-6
SLIDE 6

6

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Focus on Individual EMs

Back Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Focus on Political/Country Risk

Back

slide-7
SLIDE 7

7

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Political/Country Risk

  • Many possibilities exist to assess it
  • Credit ratings (Standard & Poor’s, Moody’s, …)
  • Country credit risk (CCR) index
  • Individual risk country guide (ICRG) index
  • 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

  • …

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Credit Ratings (S&P, Moody’s, …)

  • Usually thought of as capturing political or, more

generally, country risk

  • But they really aim to assess an issuer’s probability
  • f default
  • 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

slide-8
SLIDE 8

8

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

CCR Ratings

  • Country credit risk ratings …
  • are published twice a year by Institutional Investor
  • are based on surveys to banks
  • scale from 0 (high risk) to 100 (low risk)
  • are arbitrarily weighted by banks’ sophistication
  • Factors
  • Economic outlook
  • Debt service
  • Financial reserves
  • Fiscal policy
  • Trade balance
  • Inflow of portfolio investment
  • Foreign direct investment

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

ICRG Ratings

  • International country risk guide ratings …
  • are published monthly by Political Risk Services
  • are produced by PRS’ own analysts
  • scale from 0 (high risk) to 100 (low risk)
  • Indexes
  • Economic (Objective):

25% weight

  • Financial (Objective + subjective):

25% weight

  • Political (Subjective):

50% weight

  • Composite
slide-9
SLIDE 9

9

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

ICRG Ratings

Political Economic Financial

  • Economic expectations

versus reality

  • Economic planning

failures

  • Political leadership
  • External conflict
  • Corruption in

government

  • Military in politics
  • Organized religion in

politics

  • Law and order tradition
  • Racial and national

tensions

  • Political terrorism
  • Civil war
  • Political party

development

  • Quality of the

bureaucracy

  • Inflation
  • Debt service as a % of

exports of goods and services

  • International liquidity

ratios

  • Foreign trade collection

experience

  • Current account balance

as a % of goods and services

  • Parallel foreign exchange

rate

  • Loan default or

unfavorable loan restructuring

  • Delayed payment of

suppliers’ credit

  • Repudiation of contracts

by governments

  • Losses from exchange

controls

  • Expropriation of private

investments

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

AON’s Political Risk Map

Back GoPdf

slide-10
SLIDE 10

10

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

Where to Account for Risk?

GoXls