V O LU M E 2 2 | N U M B E R 4 | FAL L 2 0 1 0

Journal of

APPLIED CORPORATE FINANCE

A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Payout Policy and Communicating with Investors

Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance) The Value of Reputation in Corporate Finance and Investment Banking (and the Related Roles of Regulation and Market Efficiency) Maintaining a Flexible Payout Policy in a Mature Industry: The Case of Crown Cork and Seal in the Connelly Era
8

Keith Sherin, General Electric

18

Jonathan Macey, Yale Law School

30

James Ang, Florida State University, and Tom Arnold, C. Mitchell Conover, and Carol Lancaster, University of Richmond

Is Carl Icahn Good for (Long-Term) Shareholders? A Case Study in Shareholder Activism

45

Vinod Venkiteshwaran, Texas A&M University-Corpus Christi, and Subramanian R. Iyer and Ramesh P. Rao, Oklahoma State University

Drexel University Center for Corporate Governance Roundtable on Risk Management, Corporate Governance, and the Search for Long-Term Investors

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Panelists: Scott Bauguess, U.S. Securities and Exchange Commission; Jim Dunigan, PNC Asset Management Group; Damien Park, Hedge Fund Solutions; Patrick McGurn, Risk Metrics; Don Chew, Morgan Stanley. Moderated by Ralph Walkling, Drexel University.

Blockholders Are More Common in the United States Than You Might Think Private Equity in the U.K.: Building a New Future

75 86

Clifford G. Holderness, Boston College Mike Wright, Center for Management Buy-out Research and EMLyon, and Andrew Jackson and Steve Frobisher, PAConsulting Group Limited and Center for Management Buy-out Research

Should Asset Managers Hedge Their Fees at Risk? Measuring Corporate Liquidity Risk The Beta Dilemma in Emerging Markets

96 103 110

Bernd Scherer, EDHEC Business School, London Hkan Jankensgrd, Lund University Luis E. Pereiro, Universidad Torcuato Di Tella

Electronic copy available at: http://ssrn.com/abstract=1873316

The Beta Dilemma in Emerging Markets

by Luis E. Pereiro, Universidad Torcuato Di Tella*

he Capital Asset Pricing Model1 (CAPM henceforth) has provided both equity investors and corporate officers making direct investment decisions with a way to estimate present values and expected returns on investments. The CAPM framework provides financial practitioners with a measure of beta (or systematic risk) for entire stock markets, for industry subsectors, and for individual equities. Betas represent the way a particular assets returns (or an industrys returns) co-vary with the returns of a broad market index. Typically, the beta of a U.S. equity is measured against changes in the Standard & Poors 500 stock index. Betas of equities in other countries are usually measured against changes in local stock market indices. CAPM can provide a useful estimate of a firms cost of capital even if that firm does not have publicly traded shares to provide a measure of risk. Groups of similar firms (perhaps in the same industry) that do have listed shares can provide a good proxy for the risk a private firm faces. When combined with (1) some risk-free rate (usually assumed to be the yield on the relevant sovereign debt), (2) a market risk premium (the annualized rate by which local equity investors have outperformed local debt investors over long periods of time) and (3) a company-specific leverage factor, the beta of an equity can tell an investor what rate of return that investment should achieve. This same rate should also function as a hurdle rate corporate decision-makers use to assess the desirability of a particular direct investment and for someone trying to price a private asset in an emerging market. In principle, the CAPM is universally applicable to investments. In practice though, decision-makers face at least two serious predicaments in applying CAPM logic to emerging market investment assets. The first is a data predicamentthat is, relevant local data may not exist, or it can turn out to be undependable or atypical. If you try to use a pricing model based on local (domestic)

industry betas, you may find that some markets simply have no companies quoting in certain industries, and therefore, no industry betas will be available at the domestic level. For example, neither Brazil nor Russia has locally-quoted biotechnology companies. In other markets, the local price series available to compute betas are unacceptably short therefore, betas will be unreliable. In still others, even if you do find a reliable industry beta, it may still not fairly reflect the risk of its industry if the sector in question weighs heavily and disproportionately in the local markets capitalization. In Argentina, for example, a single industry, oil, accounts for 40% of total domestic market cap; in South Africa, the mining sector makes up close to 24% of local market cap; in Slovenia, the pharmaceutical industry (itself made up of a single company) represents more than one third of the local market cap. In such cases, the beta of the sector at the top of the market cap list is reflecting market, rather than industry, risk, and will not be a fair gauge of the true sectors risk.2 To avoid the data predicament, many value appraisers simply resort to using U.S. betas as surrogates for emerging market (EM) betas. In Argentina, 67% of financial advisors and private equity funds do so when valuing local companies; only 14% of them apply some kind of corrective process to U.S. data before computing a domestic cost of capital.3 Unfortunately, U.S. beta fans bump on the other side of the dilemma against an equivalence predicamentnamely, are local industry betas equivalent across borders? Intuition suggests they need not be, simply because an EM industry could well be in a different stage of development than its U.S. counterpartand thus command a very different level of risk.4 Demand for, say, soft drinks could be more sensitive to an economic recession in Latvia than in the U.S.; the riskand therefore the betaof the soft drink industry in Latvia should then be larger. Industry betas may also differ across borders due to dissimilar levels of operating and financial leverage. Despite the intuition that cross-border differences in domestic betas may exist, we still lack the empirical research needed for verification and, as a consequence, the
1. Sharpe, William F. (1964). Capital Asset PricesA Theory of Market Equilibrium Under Conditions of Risk. Journal of Finance XIX (3): 42542. 2. For additional examples, see Zenner and Akaydin (2002). 3. Pereiro (2006). 4. Damodaran (2002); Shapiro (2003).

* I would like to thank Aswath Damodaran, Martn Gonzlez-Rozada, Javier Estrada, Nora Snchez and Gustavo Vulcano for useful comments and suggestions. Luca Freira provided valuable research assistance. The views expressed below and any errors that may remain are entirely my own.

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equivalence predicament keeps haunting the analyst. This article proposes a solution to the beta dilemma. The data predicament is negotiated first, by computing domestic industry betas for a long list of EMs considered as a unique asset class. The procedure allows us to find a sizable number of betas per industry, for a large number of industries, thus automatically diluting the data predicament. We next attend to the equivalence problem by formally testing whether domestic EM and U.S. industry betas are fair proxies for each other; such tests will clearly inform value appraisers on when it is sensible to assume equivalenceand when it isnt. Solving the Data Predicament To calculate the cost of equity of an emerging-market company, many value appraisers resort to CAPM-based models that employ domestic industry betas (see Exhibit 1, Panel A for a brief review). These models, however, work well only if a local industry beta is available, is reliable, and is truly representative of its sector. In many EMs, alas, such betas are simply not there, and analysts choose to use as a reference the beta of a different emerging market, whose industry plausibly shares the risk-return pattern of the targets. In many cases, though, this strategy will still be to no avail: local betas in the alternate country may still be lacking, undependable, or atypical. The data predicament can be approached by aggregating EMs into a single asset class. Such grouping, which allows for finding a large enough number of valid industry betas, is predicated on the fact that, in contrast to the U.S., emerging stock markets share a number of risk-related characteristics: small absolute and relative size, low liquidity, higher leverage, heavy concentration, and high volatility. China, nowadays the center of gravity of Asian markets, represents less than 19% of U.S. market cap; India, less than 9%; and Brazil, less than 6%. The importance of EMs in their respective economies is likewise smaller: the median weight of the stock market as a percentage of GNP is about 40% in EMs; the figure in the U.S.: 180%. Smallness goes hand in hand with lower liquidity, which in EMs is only one third of the U.S.s.5 The median market debt-to-assets ratio is 16.6% in EMs and 15.4% in the U.S. Add to that concentrationwhich can and often does lead to price manipulation: the top 10 largest firms in EMs represent about 56% of total market cap; in the NYSE, the figure is 23%.6 Finally, EM returns march alongside large volatilities: the long-term annual return in the U.S. is 8.1%, at an annual volatility of 16.2%; the return figure for EMs is about 9.1% a yearat an annual volatility of 34.8%.7 Similar
5. Based on data from Lesmond (2005) and Lesmond, Ogden and Trzcinka (1999). 6. Pereiro (2001a). 7. Computed over 19201996 by Goetzmann and Jorion (1999). 8. The class included, in fact, a mixture of emerging, frontier, and less-developed stock markets: Argentina, Bahamas, Bahrain, Bangladesh, Bermudas, Bolivia, Botswana, Brazil, Bulgaria, Cayman, Chile, China, Colombia, Costa Rica, Croatia, Cyprus, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Fiji, Ghana, Guatemala, Hong Kong, Hungary, India, Indonesia, Iran, Israel, Ivory Coast, Jamaica,

risk features across EMs are so contrasting to those in the U.S., that we feel justified in grouping EMs into a single, distinctive asset classwhich is exactly what international portfolio managers have been doing for years. To illustrate the aggregation procedure, we defined EMs as a broad asset class comprising 81 stock markets,8 and collected the betas of all their public firms by January 1st, 2010. Betas had been computed by Bloomberg over a 5-year window by regressing weekly U.S.-dollar based returns on the most important local index. For the U.S., the original data came from ValueLine, betas being computed over a 5-year window by regressing weekly returns against the NYSE Composite Index. We purified the data by eliminating companies in financial distress (as signaled by a zero or negative book value of equity, or by a negative bookto-equity ratio), and finally screened out companies with nil or negative betas, which are useless for cost-of-capital computations. Observable firm betas reflect the current financial leverage of the firms in question, and are therefore financially levered betas. From these we cleansed the effect of financial leverage by computing unlevered firm betas: Unlevered Beta = Levered Beta / [1+ (1-T) x D/E] (1)

where T is the corporate tax rate, and D/E is the marketmarked financial leverage of the firm in question.9 We are interested in unlevered betas since these are, for private firms, the standard starting point in cost-of-capital computations: the unlevered beta is re-levered with the D/E ratio of the firm under valuation and introduced into any of the models available for cost-of-capital calculations. Going a step further, we computed total firm betas. A total beta gauges the total risk of a stock (i.e., that stocks systematic plus unsystematic risks); it is defined as the full volatility of the stock relative to the markets: Total Beta= [Standard Deviation of Firms Stock Returns / Standard Deviation of Markets Returns] (2)

We are interested in total beta because it is a most useful risk measure for undiversified investorse.g., private-firm owners whose wealth is concentrated into a single stock and thus bear the handicap of nil diversification. Also, total beta works well as a maximum extreme reference for partially diversified investorsi.e., those whose portfolios comprise just a few stocks
Jordan, Kazakhstan, Kenya, Kuwait, Latvia, Lebanon, Liberia, Lithuania, Malawi, Malaysia, Mauritius, Mexico, Morocco, Namibia, Nicaragua, Nigeria, Oman, Pakistan, Palestine, Panama, Paraguay, Peru, Philippines, Poland, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Sri Lanka, Swaziland, Taiwan, Thailand, Trinidad, Tunisia, Turkey, U.A.E., Ukraine, Uruguay, Venezuela, Vietnam, Zambia, and Zimbabwe. We call the whole class emerging for simplicity. 9. This is the classic Hamadas (1972) formula.

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and thus bear the handicap of partial, or incomplete, diversification; for these investors, true betas will lie somewhere between regular and total betas. (Since totally or partially undiversified investors are legion,10 analysts have developed several models to deal with their special diversification status; some appear in Exhibit 1, Panel A.) Total betas can be computed from regular betas by using the following equation: Total Unlevered Beta = [Unlevered Beta / Rho] (3)

apply, without further regrets, a pricing model that employs a straight U.S. beta (see Exhibit 1, Panel B, for a brief review of these models). Solving the Equivalence Predicament Another way to solve the data predicament would be to apply U.S. domestic betas directly to EMs; but this strategy is fraught with danger because local industry betas may not be equivalent across asset classes.12 The last column in Exhibit 2 shows that close to 80% of industry betas are not equivalent across classes. Consequently, we can justify using U.S. betas as sensible surrogates for domestic EM betas for only a handful of industries. Look next at the results reported in the last column of Exhibit 3: total betas turn out to be significantly different between asset classes for about 30% of the sample. The overall conclusion is telling: U.S. betas should not be directly applied to EMs unless cross-border beta equivalence has been adequately proven in the first place. Fickle Risk, Beta Waves A closer look at Exhibit 2 reveals a striking find: all industry betas that are significantly different across classes are smaller in EMs. In fact, the median of medians in EMs is 0.37less than half the U.S. norm of 0.84. Since differences in development, or in operating leverage, may produce larger or smaller betas across asset classes, our consistent find of smaller betas in EMs is somewhat troubling. Is there a problem in the data? The problem is not in the data, but in the fact that betas and total betas are inter-temporally unstable risk measuresi.e., they change over time. A stocks risk, as noted, has several components: the degree of operating leverage; the potential obsolescence of the product or service offered; the strength of the competition; the position of the industry in its life cycle (which affects the sensitivity of the demand to economic conditions); the vulnerability of operations to external financing via credit or equity (in a dry market, financing is difficult or impossible); and even investor sentiment. All these components are bound to vary as time elapses, and so are risk metricsbetas and total betas.13
used only if betas are normally distributed in both asset classes. We used the ShapiroWilk (S-W) test to test for such dual normality and applied the t-test only to those industries in which the condition verified. (By definition, the t-test tests differences between means, not medians; yet in normally-distributed data, mean and median coincide because of symmetry, therefore testing means is equivalent to testing medianswhich is our goal). Where dual normality was not present, we applied a non-parametric testthe Wald-Wolfovitz (W-W) Runs, a tool that tests not only the location (median) of the distribution but also its shapehence being a very comprehensive test. The choice of the S-W and W-W tests is predicated on the fact that they work better for small samplesfewer than 2,000which are the norm in industry beta datasets. A good tip is to use always exact tests of significance, since these can handle small samples, sparse tables, and unbalanced designsfeatures that are likely to appear in many an industry. 13. Financial leverage is also a risk component, but we have cleansed its effects from our data by working with unlevered betas.

where Rho is the correlation coefficient of the stocks return against the markets.11 Rho is a simple measure of how sensitive a particular stocks return is to general economic conditions, as reflected in the stock market. The next-to-last step was to group betas and total betas according to industry. Since Bloomberg and Value Line classify industries differently, we constructed our own set of categories by checking out each companys SIC/NAICS number and, when necessary, resorting to individual company reports, to properly sort each firm into the right industry. Finally, we computed industry medians for betas and total betas. The median is a standard measure of centrality widely used in corporate valuation because it is impervious to outliers (in contrast to arithmetic means; outliers frequently crop up in beta samples). After discarding sectors with fewer than 10 firms, we were left with 66 industries whose betas and total betas appear in Exhibits 2 and 3, respectively. Courtesy of the aggregation procedure, the value appraiser can simply look into our tables to find a plausible industry beta for an emerging market. Since our betas have been computed against local market indexes, they should be reflecting domestic industry risk fairly well, thus being the perfect fit for models that employ local betas. The aggregation solution works well, of course, only if one believes that the industry beta of the average EM is a good match for its analogue in the specific emerging market (say, Latvia) in which the target company operates. If not, one may well be facing an industry whose risk-return dynamics (and beta) are instead akin to those of developed markets; being the U.S. a good proxy for the latter, in such cases one could
10. The existence of imperfectly diversified investors has been reported on: majority shareholders in family-owned companies (Moskowitz and Vissing-Jorgensen, 2002); venture capitalists (Norton and Tenenbaum, 1993; Schertler, 2001); angel investors (Freear, Sohl and Wetzel, 1997; Pereiro, 2001b); individuals investing in the U.S. stock market (Blume and Friend, 1975; Lease, Lewellen and Schlarbaum, 1976; Barber and Odean, 2000; Huberman, 2001; Ivkovic and Weisbenner, 2003); corporate employees (Benartzi, 2001); and international portfolio managers (Karolyi and Stulz, 2002). 11. Let RT= Alpha + Beta. RM; where RT is the total return of the stock and RM the market return. V(RT)= Beta2. V(RM), where V is the variance. On the other hand, V(RT) can be de-composed in one systematic and one unsystematic risk components, like this: V(RT)= R2.V(RT) + (1-R2). V(RT). Using both identities: V (RT)= Beta2. V(RM) = Rho2. V(RT), from where V(RT) = Beta2. V(RM)/Rho2. Extracting the square root in both terms: Standard Deviation (RT) = (Beta/Rho). Standard Deviation(RM). From where the beta of the total return, or total beta, is (Beta/Rho). 12. Testing for equivalence is akin to testing the difference of medians. The most powerful difference-of-medians test is Pearsons t-test but, being parametric, it can be

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How, exactly, have betas been evolving lately? Exhibit 4 lets us peek at the answer: between 2007 and 2010, the median of medians for U.S. industry betas remained fairly stable (it climbed slightly from 0.83 to 0.85, but the change was statistically insignificant); while the median in EMs dropped sharplyfrom 0.94 to 0.39, a highly significant difference. In other words, EMs became less risky on average over that period. Panels B1 and B2 in Exhibit 4 graphically reinforce our argument: the beta probability distributionor beta wavestays in about the same place in the U.S., but shifts dramatically to the left (i.e., to less risky terrain) in EMs. It is this shift, precisely, that may be accountable for our finding that all industry betas were, as of the dawn of 2010, smaller in EMs than in the U.S. As for total industry betas, some turn out to be larger in the U.S., and some others dont; but in any case, U.S. median total beta increased significantlygoing from 1.66 in January 2007 to 2.36 in January 2010. In consonance, Panels B3 and B4 in Exhibit 4 illustrate how the total beta wave in the U.S. displaces heavily to the right, i.e., to riskier terrain. The reason behind this shift has almost certainly been the subprime credit crisis.14 In stark contrast, the median total beta for EMs decreased over the same periodshifting significantly from 2.44 to 2.02. How come U.S. total beta increased while U.S. beta remained stable? The answer lies in the evolution of Rhothe correlation. Recall that beta equals total beta divided by Rho. Over the time stretch under analysis, U.S. total beta went up while Rho went downin such a way that beta was left virtually unscathed. Not in EMs, though: here, while Rho likewise decreased over time, on balance, beta decreased significantly. Now, since Rho went down in both the U.S. and EMs, it seems that in both asset classes, the idiosyncratic, or non-diversifiable portion of total risk prevailed over the market-related portion (i.e., that measured by beta).

In summary, betas and total betas do change over time with the gyrations of stock markets, and this warrants a stern caveat: if we employ the aggregation procedure to solve the data predicament, we must take the precaution to update our datasets from time to time. Asset Pricing with the Beta Solution The choice of a cost of equity model for an emerging-market firm is very personal: it depends on how conceptually sound the model looks to the analyst, and on her view on which risks canand which cannotbe diversified away by the investor. The choice done, the analyst faces the challenge of finding a plausible beta to plug into the selected modeland at this point is when the solution to the beta dilemma becomes helpful (see Exhibit 5). Those who prefer using local pricing models but are unable to find plausible local betas in the emerging market, can use the industry beta of (a) another EM, suspected to have a similar risk-return industry dynamics (and, as long as such beta is available, reliable, and representative); or (b), as we have argued, the beta of the whole EM class. Relying on U.S. betas head-on is, we explained, a dangerous approach, since betas may be significantly different across classes. If the risk-return dynamics of the industry in the target EM is suspected to be different from that of the EM class as a whole, why not assume that such market is rather following the dynamics of developed markets? Being the U.S. the epitome of such, using a U.S.-beta-based pricing model will be a fair strategy to apply in such occasions. All in all, solving the beta dilemma clarifies when it is sensible to use a local, and when a U.S.-based, asset pricing model. luis e. pereiro is Professor of Finance at the Business School, Universidad Torcuato Di Tella in Buenos Aires, Argentina. He is also the author of Valuation of Companies in Emerging Markets: A Practical Approach, John Wiley & Sons (2002).

14. The first symptoms of the credit crunch appeared in January/February 2007, when the ABX index, which tracks credit default-swaps based on bonds backed by subprime mortgages, started deteriorating heavily. The fallout became more evident by April 2007, when New Century Financial, the largest subprime lender in the U.S., filed for bankruptcy. January 1, 2007 thus seems to be a sensible pre-crisis comparison point.

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References Barber B.M. and T. Odean (2000). Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Journal of Finance, 55, 773806. Benartzi, S. (2001). Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock. Journal of Finance, 56, 17471764. Blume, M. and I. Friend (1975). The Asset Structure of Individual Portfolios and Some Implications for Utility Functions. Journal of Finance, 30, 585603. Damodaran, Aswath (2002). Investment Valuation. John Wiley & Sons, New York. Freear, J., Sohl, J.E. and W.E. Wetzel, Jr. (1997). The Informal Venture Capital Market: Milestones Passed and the Road Ahead. in Sexton, D.L. & R.W. Smilor (Eds.), Entrepreneurship 2000, Upstart Publishing Company, Chicago. Goetzmann, W.N. and P. Jorion (1999). Re-Emerging Markets. Journal of Financial and Quantitative Analysis, 34, 131. Hamada, R.S. (1972). The Effect of the Firms Capital Structure on the Systematic Risk of Common Stocks. Journal of Finance, 27, 435452. Huberman, G. (2001). Familiarity Breeds Investment. Review of Financial Studies, 14, 659680. Ivkovic, Z. and S. Weisbenner (2003). Local Does as Local Is: Information Content of Geography of Individual Investors Common Stock Investments. NBER Working Paper No. 9685. Karolyi, G.A. and R.M. Stulz (2002). Are Financial Assets Priced Locally or Globally? NBER Working Paper No. W8994. Lease, R.C., Lewellen, W.G. and G.G. Schlarbaum (1976). Market Segmentation: Evidence on the Individual Investor. Financial Analysts Journal (Sep-Oct), 5360. Lesmond, D.A. (2005). Liquidity of Emerging Markets. Journal of Financial Economics, 77, 411452.

Lesmond, D., Ogden, J., Trzcinca, C. (1999). A New Estimate of Transaction Costs. Review of Financial Studies, 12, 11131141. Lessard, D. (1996). Incorporating Country Risk in the Valuation of Offshore Projects. Journal of Applied Corporate Finance, 9, 5263. Mariscal, J.O. and K. Hargis (1999). A Long-Term Perspective on Short-Term Risk. Goldman Sachs Investment Research. Moskowitz, T.J. and A. Vissing-Jorgensen (2002). The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle? American Economic Review, 92, 745778. Norton, E. and B.H. Tenenbaum (1993). The Effects of Venture Capitalists Characteristics on the Structure of the Venture Capital Deal. Journal of Small Business Management (October), 3241. Pereiro, L.E. (2006). The Practice of Investment Valuation in Emerging Markets: Evidence from Argentina. Journal of Multinational Financial Management, 16, 160183. Pereiro, L.E. (2001a). The Valuation of Closely-Held Companies in Latin America. Emerging Markets Review, 2, 330370. Pereiro, L.E. (2001b). Tango and Cash: Entrepreneurial Finance and Venture Capital in Argentina. Venture Capital, 3, 291308. Schertler, A. (2001). Venture Capital in Europes Common Market: A Quantitative Description. EIFC Technology and Finance Working Papers 4, United Nations University, Institute for New Technologies. Shapiro, A.C. (2003). Multinational Financial Management (Seventh Edition), John Wiley & Sons, New York. Zenner, M. and Akaydin, E. (2002). A Practical Approach to the International Valuation and Capital Allocation Puzzle. Global Corporate Finance Papers, Salomon Smith Barney.

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Appendix
Exhibit 1 CAPM-Based Cost of Equity Models Used in Emerging Markets Valuation
Panel A
Model 1. Local CAPM (L-CAPM); adapted from Pereiro (2001a)

Models Using Local (Domestic) Betas

Description CE = Rf US + RC + BLL . (RM L Rf L) where CE is the cost of equity capital, Rf US is the U.S. risk-free rate, RC is a country risk premium, BLL is the beta of a comparable local company (or industry) computed against a local (i.e., emerging) market index, and RM L the return of the local stock market. The country risk premium RC is usually computed as the spread of dollar-denominated sovereign bonds over American T-bonds of similar denomination, yield and term. This model fits a partially diversified investor: the use of beta suggests the investor is fully diversified at the domestic company (or industry) level, but unable to diversify at the country level. CE = Rf US+ RC + BLL . (RM L Rf L) . (1 - R2) where R2 may be thought of as the amount of variance in the equity volatility of the target company that is explained by country risk. This model is an improvement over the Local CAPM, since the last term compensates for the double-counting of country risk implied in using both RC and RM L in the same equation. Again, the model fits a partially diversified investor: well-diversified at the local firm (or industry) level, but unable to diversify at the country level. CE = Rf US+ RC + BT LL . (RM L Rf L) . (1 - R2) where BTLL is the total beta of a comparable local company (or industry) computed against a local market index. BT is computed as the standard deviation of the return of a local comparable company (industry), divided by the standard deviation of the return of the local market. This model is conceptually equivalent to the AL-CAPM but applies instead to fully undiversified investors, since a total beta is used. CE = Rf US+ BTLL . (RM US Rf US) . BT L,US In this model, country risk is incorporated by calibrating the U.S. market risk premium to the local (emerging) market via a total country beta, or BTL,US, equal to the standard deviation of returns in the local equity market divided by the standard deviation of returns in the U.S. market. Since the RC factor is not used, no correction for risk double-counting is needed. The model is hybrid in the sense that it combines EM data with U.S. data. Like the FRAL-CAPM, this model applies to fully undiversified investorsi.e., to those unable to diversify company, industry, and country risk. CE = Rf US + R C + B LL. (RM US Rf US) . BT L,US . (1 R) + RId where RM US is the return of the U.S. stock market index, and R is the correlation of dollar returns between the local stock market and the sovereign bond used to measure country risk. While (1-R) is used to alleviate the problem of double counting country risk, the problem is not fully solved, since the model also includes BTL,US in the same equation. A special feature of the model is RId, an idiosyncratic risk premium related to the special features of the target firm (e.g., specific firm credit rating as embodied in its corporate debt spread, industry cyclicality, percentage of revenues coming from the target country, etc). This model fits a partially diversified investor: the use of BLL suggests the investor is well diversified at the local company (or industry) level, but unable to diversify at the country level. CE = Rf US + R C . Gamma + B LL . (RM US Rf US) where Gamma is a firm-specific exposure to country risk ranging from zero to one, and B LL is the local company beta computed against a local market index. The exposure factor Gamma could be, for instance, the percentage of revenues to the parent firm coming from the local (emerging) market. The use of the RC factor suggests, again, that the investor is unable to diversify country risk; yet the use of BLL suggests the investor is able to diversify company (or industry) risk.

2. Adjusted Local CAPM (AL-CAPM); adapted from Pereiro (2001a)

3. Full Risk Adjusted Local CAPM (FRAL-CAPM)

4. Full Risk Hybrid Local CAPM (FRHL-CAPM)

5. Goldman-Sachs (G-S) Model; adapted from Mariscal and Hargis (1999)

6. Gamma Model; Damodaran (2002)

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Panel B
Model

Models Using U.S. Betas

Description CE = Rf US + RC + BCL,US . BUS . (RM US Rf US) where RC is a country risk premium that includes the chance of expropriatory actions, payment difficulties and other risks, BCL,US is the country beta (the relative sensitivity of the returns of the local stock market to the U.S. markets), and BUS is the beta of a U.S.-based project whose risk pattern is comparable to the offshore project. The country risk premium can be computed as a sovereign bond yield spread against U.S. treasuries, as an OPIC insurance premium, or indirectly derived from political risk ratings. The simultaneous use of RC and BCL,US without any further correction suggests the model double-counts country risk. The use of a U.S. beta suggests the investor is well-diversified at the firm (or industry) level, but unable to diversify at the country level. This model (and all other models within this panel) implicitly assumes that a U.S. firm (or industry) beta is a plausible surrogate for the local EM beta. CE = Rf US+ RC + BCL,US . BUS . (RM US Rf US) . (1 R2) where BUS is the average unlevered beta of comparable companies quoting in the U.S. market, relevered with the financial structure of the target company, and R2 is the coefficient of determination of the regression between the equity volatility of the local market against the variation in country risk. Conceptually similar to Lessards model, but attempts to correct for the double counting of country risk by including the (1 - R2) factor. R2 can be thought of as the amount of variance in the volatility of the local equity market that is explained by country risk. Like Lessards, this model applies to an investor that is well-diversified at the firm (or industry) level, but unable to diversify at the country level. CE = Rf US+ BTUS . (RM US Rf US) . BT L,US This model is identical to the FRHL-CAPM, except that it uses a total U.S. beta instead of a total local beta. BTUS is the total beta of a comparable U.S. company (or industry) computed against the U.S. market index. Like the FRHL-CAPM, this model incorporates country risk by calibrating the U.S. market risk premium to the local (emerging) market via the total country beta BTL,US. In this aspect, the model is similar to the G-S model; but in contrast, the Rc factor is not used here, and thats why no correction for risk double counting is needed. Like the FRAL- and FRHL-CAPMs, this model applies to fully undiversified investorsi.e., to those unable to diversify company, industry, and country risks. The model uses a total U.S. beta which, as this article purports, may not necessarily be a good proxy for its emerging market counterpart.

7. Lessards Model Lessard (1996)

8. Adjusted Hybrid CAPM (AH-CAPM) (adapted from Pereiro, 2001a)

9. Full Risk Hybrid U.S. CAPM (FRHUS-CAPM)

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Exhibit 2 Betas: Industry Medians in Emerging Markets and the U.S. Market, 2010
This exhibit shows industry medians of unlevered betas for 66 sectors as of January 1, 2010. Industries with betas normally distributed in both EM and U.S. data have been tested with the t-test; all others have been tested with the Wald-Wolfovitz (W-W) Runs test. Significances of 0.1 or smaller lead to reject the null hypothesis that median betas in EMs and the U.S. are not statistically different. The median of medians in EMs, 0.37, is significantly different from the U.S.s, 0.84 (W-W statistic: -7.864; significance: 0.00).

Unlevered Betas

Tests of Normality: Shapiro-Wilk Significance BetaUS 0.90 0.80 0.53 0.90 1.05 0.73 0.58 0.90 0.83 0.66 1.12 0.97 0.88 1.33 0.94 0.85 1.20 0.36 0.82 0.63 0.44 0.95 0.89 0.69 0.65 0.99 0.71 0.61 0.59 0.44 0.85 0.82 EMBetas 0.00 0.01 0.00 0.00 0.00 0.00 0.00 0.12 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.03 0.05 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.12 0.00 0.00 USBetas 0.09 0.04 0.34 0.65 0.05 0.55 0.71 0.31 0.27 0.30 0.34 0.46 0.81 0.84 0.42 0.00 0.94 0.02 0.19 0.04 0.00 0.81 0.00 0.36 0.13 0.02 0.03 0.35 0.83 0.15 0.95 0.17 Both normal? No No No No No No No Yes No No No No No No No No No No No No No No No No No No No No No Yes No No

Test of the Difference of Medians: Significances t-test W-W Test Medians different? Yes Yes No Yes Yes Yes Yes Yes Yes No Yes Yes Yes Yes Yes Yes No No Yes No Yes Yes Yes Yes No Yes Yes Yes Yes No Yes Yes

Industry

NEM 26 21 43 325 156 45 84 28 97 43 248 48 171 37 189 405 396 185 25 18 175 258 457 48 39 103 83 303 25 16 80 168

NUS 18 51 34 37 35 15 27 54 39 13 13 25 65 17 86 228 12 25 13 25 60 63 148 49 50 22 125 82 15 13 28 46

BetaEM 0.40 0.31 0.37 0.32 0.35 0.31 0.31 0.41 0.29 0.46 0.35 0.31 0.37 0.61 0.43 0.52 0.40 0.30 0.39 0.31 0.24 0.40 0.44 0.36 0.58 0.46 0.28 0.32 0.36 0.44 0.36 0.40

Advertising Aerospace/Defense Air transportation Apparel/Textile Auto parts Auto/Truck Beverages Biotechnology Building materials Cable TV/TV/Radio Chemical-Basic Chemical-Diversifed Chemical-Specialty Coal Computer-Hardware/Equipment Computer-Software/Services Construction-Heavy/Engineering Construction-Residential/Commercial Cosmetics/Personal care Educational services Electric utility Electrical equipment Electronics Entertainment Environmental Financial services-Brokerage/Investment banking Financial services-Diversified Food-Processing Food-Retail/Supermarkets Food-Wholesalers Furniture/Home decoration Hotel/Casino

0.00 0.82 -

0.01 0.00 0.50 0.00 0.00 0.01 0.02 0.01 0.01 0.78 0.00 0.00 0.00 0.05 0.00 0.00 0.13 0.49 0.02 0.04 0.00 0.00 0.00 0.02 0.15 0.03 0.00 0.08 0.02 0.52 0.02 0.07

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Exhibit 2 continued Industry Household products Industrial services Information services Internet Machinery Maritime transportation Medical services Medical supplies Metal fabricating Mining Natural gas Office Equipment/Supplies Oilfield services/equipment Oil-Integrated Oil-Producing Packaging/Container Paper/Forest products Pharmaceuticals Pharmacy services Printing/Publishing Real Estate-Services/Development Recreation/Leisure time Retail Store Retail-Automotive Retail-Restaurant Semiconductor Semiconductor equipment Shoe Steel Telecom-Equipment Telecom-Services Telecom-Wireless/Cellular/Satellite Trucking Water utility Total (66 industries) Minimum Maximum Mean of Medians Median of Medians NEM 75 186 16 89 278 118 52 48 45 168 47 29 106 19 33 85 104 224 24 66 516 50 184 21 32 247 87 22 199 198 86 49 39 32 7,919

Unlevered Betas NUS 20 115 19 99 93 47 102 176 26 68 72 16 93 24 126 24 29 179 16 18 13 46 159 14 55 98 13 17 31 81 87 38 31 13 3,591 0.20 0.69 0.39 0.37 0.36 1.33 0.82 0.84 BetaEM 0.27 0.32 0.67 0.66 0.39 0.33 0.31 0.48 0.31 0.53 0.40 0.36 0.38 0.69 0.69 0.26 0.32 0.38 0.33 0.33 0.36 0.37 0.42 0.20 0.46 0.51 0.49 0.51 0.36 0.53 0.37 0.37 0.28 0.23 BetaUS 0.71 0.72 0.85 0.93 0.93 0.57 0.75 0.81 1.03 1.16 0.54 0.77 1.06 0.98 0.98 0.76 0.76 0.85 0.71 0.85 0.55 0.72 0.86 0.76 0.78 1.04 1.05 0.94 1.10 0.85 0.66 1.00 0.85 0.49

Tests of Normality: Shapiro-Wilk Significance EMBetas 0.00 0.00 0.67 0.01 0.00 0.00 0.01 0.00 0.00 0.00 0.00 0.06 0.00 0.97 0.22 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.02 0.48 0.00 0.00 0.11 0.00 0.00 0.00 0.00 0.00 0.00 USBetas 0.33 0.42 0.16 0.05 0.16 0.06 0.08 0.00 0.29 0.25 0.02 0.48 0.35 0.17 0.16 0.31 0.29 0.50 0.09 0.83 0.55 0.90 0.00 0.08 0.33 0.00 0.41 0.98 0.12 0.11 0.26 0.04 0.21 0.00 Both normal? No No Yes No No No No No No No No No No Yes Yes No No No No No No No No No Yes No No Yes No No No No No No

Test of the Difference of Medians: Significances t-test 0.22 0.01 0.08 0.00 0.00 W-W Test 0.00 0.00 0.16 0.01 0.00 0.16 0.00 0.00 0.01 0.00 0.03 0.00 0.00 0.20 0.74 0.00 0.00 0.00 0.00 0.08 0.72 0.00 0.00 0.00 0.10 0.00 0.00 0.78 0.00 0.00 0.35 0.00 0.01 0.01 Medians different? Yes Yes No Yes Yes No Yes Yes Yes Yes Yes Yes Yes No No Yes Yes Yes Yes Yes No Yes Yes Yes Yes Yes Yes No Yes Yes No Yes Yes Yes

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Exhibit 3 Total Betas: Industry Medians in Emerging Markets and the U.S. Market, 2010
This exhibit shows median unlevered total betas for 66 industries as of January 1, 2010. All industries in the exhibit have non-normally distributed betas in EM, the U.S. or both; and have therefore been tested with the Wald-Wolfovitz (W-W) Runs test. Significances of 0.1 or smaller lead to reject the null hypothesis that median total betas in EMs and the U.S. are not statistically different. The median of medians in EMs, 2.16, is not significantly different from the U.S.s, 2.45 (W-W statistic: -5.24; significance: 0.30).
Unlevered Total Betas Industry Advertising Aerospace/Defense Air transportation Apparel/Textile Auto parts Auto/Truck Beverages Biotechnology Building materials Cable TV/TV/Radio Chemical-Basic Chemical-Diversifed Chemical-Specialty Coal Computer-Hardware/Equipment Computer-Software/Services Construction-Heavy/Engineering Construction-Residential/Commercial Cosmetics/Personal care Educational services Electric utility Electrical equipment Electronics Entertainment Environmental Financial services-Brokerage/Investment banking Financial services-Diversified Food-Processing Food-Retail/Supermarkets Food-Wholesalers Furniture/Home decoration Hotel/Casino Household products NEM 26 20 41 291 145 41 75 25 87 40 226 46 153 35 175 372 362 168 24 15 155 238 430 42 39 94 79 271 25 15 71 153 66 NUS 14 45 28 34 28 15 25 45 32 11 12 23 58 16 79 163 11 21 12 22 59 58 133 39 37 21 103 74 12 13 26 41 20 Total BetaEM 2.36 2.79 1.44 2.34 2.15 2.59 1.82 2.74 2.14 1.96 2.39 2.55 2.29 4.17 3.33 2.66 2.14 2.01 2.09 2.35 1.56 2.63 2.96 2.86 2.79 1.87 1.13 1.70 1.81 2.08 2.37 1.91 2.17 Total BetaUS 3.25 2.39 1.89 2.89 2.88 1.87 1.83 3.53 2.36 1.73 3.04 2.29 2.46 2.78 3.46 2.85 2.84 1.34 2.07 2.70 0.87 2.75 3.05 2.71 2.81 2.58 2.40 1.79 1.70 1.55 2.87 2.44 1.83 Tests of Normality: Shapiro-Wilk Significance EMTotal Betas 0.23 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.03 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.05 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.05 0.00 0.00 0.00 USTotal Betas 0.00 0.00 0.00 0.00 0.51 0.15 0.00 0.00 0.05 0.07 0.29 0.00 0.00 0.62 0.00 0.00 0.53 0.59 0.00 0.77 0.00 0.00 0.00 0.00 0.03 0.00 0.00 0.00 0.25 0.02 0.00 0.57 0.05 Both normal? No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No Test of the Difference of Medians: Significances W-W Test 0.50 0.14 0.75 0.40 0.03 0.51 0.17 0.05 0.43 0.30 0.80 0.03 0.56 0.63 0.45 0.55 0.73 0.84 0.50 0.21 0.00 0.34 0.31 0.29 0.13 0.09 0.00 0.48 0.81 0.09 0.49 0.28 0.42 Medians different? No No No No Yes No No Yes No No No Yes No No No No No No No No Yes No No No Yes Yes Yes No No Yes No No No

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Exhibit 3 continued Industry Industrial services Information services Internet Machinery Maritime transportation Medical services Medical supplies Metal fabricating Mining Natural gas Office Equipment/Supplies Oilfield services/equipment Oil-Integrated Oil-Producing Packaging/Container Paper/Forest products Pharmaceuticals Pharmacy services Printing/Publishing Real Estate-Services/Development Recreation/Leisure time Retail Store Retail-Automotive Retail-Restaurant Semiconductor Semiconductor equipment Shoe Steel Telecom-Equipment Telecom-Services Telecom-Wireless/Cellular/Satellite Trucking Water utility Total (66 industries) Minimum Maximum Mean of Medians Median of Medians NEM 169 15 86 251 112 49 45 42 156 48 27 100 18 32 77 98 199 20 61 480 45 169 20 26 225 83 22 182 191 80 47 35 29 7,284

Unlevered Total Betas NUS 99 17 80 92 34 89 157 20 52 68 15 83 24 93 20 26 144 10 16 8 41 148 14 52 86 13 17 27 69 69 32 30 11 3,086 1.13 4.17 2.22 2.16 0.87 3.53 2.39 2.45 Total BetaEM 2.12 1.75 2.95 2.42 1.72 1.45 2.29 1.65 2.78 1.28 2.14 2.07 1.95 2.21 1.69 1.68 2.25 2.27 2.27 2.09 2.42 2.07 1.57 2.48 3.82 2.51 1.62 1.81 2.74 1.48 1.41 2.28 3.21 Total BetaUS 2.34 2.18 3.33 2.42 1.13 2.47 2.91 2.50 3.47 1.05 2.27 2.59 2.01 2.77 1.90 1.90 3.46 1.92 2.61 1.55 2.17 2.83 1.80 2.44 3.07 2.62 2.52 2.64 2.89 2.04 2.79 2.01 1.11

Tests of Normality: Shapiro-Wilk Significance EMTotal Betas 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.04 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.00 0.00 0.00 0.00 0.00 0.00 USTotal Betas 0.00 0.30 0.00 0.00 0.00 0.00 0.00 0.53 0.00 0.00 0.42 0.00 0.31 0.00 0.69 0.38 0.00 0.02 0.70 0.76 0.00 0.00 0.03 0.00 0.04 0.00 0.06 0.77 0.00 0.00 0.00 1.00 0.00 Both normal? No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No No

Test of the Difference of Medians: Significances W-W Test 0.22 0.98 0.08 0.46 0.49 0.01 0.27 0.18 0.01 0.40 0.86 0.06 0.49 0.35 0.00 0.20 0.74 0.36 0.59 0.65 0.75 0.29 0.02 0.53 0.05 0.14 0.29 0.62 0.09 0.37 0.00 0.00 0.28 Medians different? No No Yes No No Yes No No Yes No No Yes No No Yes No No No No No No No Yes No Yes No No No Yes No Yes Yes No

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Exhibit 4 The Evolution of Industry Betas, 20072010

Panel A of this exhibit shows the evolution of the industry medians for three parameters: beta, total beta, and correlation. Since over time some companies enter stock markets, while others exit them, analyzing all companies quoting at a given time may yield a distorted view of the parameters evolution. To avoid this survivorship bias, the parameters have been computed for groups of identical companies within each asset class. The U.S. panel comprised 2,265 firms in 76 industries; the EM panel, 2,765 firms in 74 industries. Differences between distributions medians were tested with the Wald-Wolfovitz (W-W) test, whereby significances of 0.1 or smaller imply that the distributions location and shape are significantly different between asset classes. Panel B graphs the evolution of beta and total beta waves in each asset class.

Panel A
W-W Test, 2007 vs. 2010 Jan 2007 Unlevered Beta (median of medians) W-W Test, U.S. vs. EM U.S. EM W-W statistic Significance Unlevered total beta (median of medians) W-W Test, U.S. vs. EM U.S. EM W-W statistic Significance Correlation (Rho) (median of medians) W-W Test, U.S. vs. EM U.S. EM W-W statistic Significance 0.83 0.94 0.166 0.57 1.66 2.44 -3.112 0.00 0.48 0.38 -3.603 0.00 Jan 2010 0.85 0.39 -8.52 0.00 2.36 2.02 -2.456 0.01 0.36 0.19 -7.045 0.00 -4.720 -6.104 0.00 0.00 -1.953 -4.619 0.03 0.00 W-W statistic 0.977 -9.073 Significance 0.84 0.00

Panel B
B1. U.S. Industry Betas: 2007 (back) vs. 2010 (front) 25% 40% 20% 15% 10% 5% 0% 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 Median Unlevered Beta B3. U.S. Total Industry Betas: 2007 (back) vs. 2010 (front) 20% 50% B2. EM Industry Betas: 2007 (back) vs. 2010 (front)

Probability

Probability

30% 20% 10% 0% 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 Median Unlevered Beta B4. EM Total Industry Betas: 2007 (back) vs. 2010 (front)

Probability

Probability

15% 10% 5% 0% 0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3 2.5 2.8 3.0 3.3 3.5 Median Unlevered Total Beta

40% 30% 20% 10% 0% 0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3 2.5 2.8 3.0 3.3 3.5 Median Unlevered Total Beta

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Exhibit 5 Choosing an Asset Pricing Model in Emerging Markets (EMs)

Yes: Use local industry beta of EM ...a local EM industry beta Is a good industry beta available in the EM? No: Is there another EM with a similar industry dynamics and good beta?

Yes: Use local industry beta of EM

Choose a pricing model that uses...

...a U.S. industry beta

Is the U.S.s industry dynamics a good proxy for that of the EM in question?

Yes: Use U.S. industry beta No: Consider using a pricing model with a local EM industry beta

No: Is the industry dynamics in the EM class a good proxy for that of the EM in questions?

Yes: Use industry beta of EM class

No: Assimilate the EM to a developed market and use a pricing model with a U.S. industry beta

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