PM40 Risk Analysis and

Project Appraisal and Risk Management (PARM) Duke Center for International Development at the Sanford Institute May
27-28, 2002
Risk Analysis and Project Evaluation

Campbell R. Harvey
Duke University and National Bureau of Economic Research

Plan
1. 2. 3. 4. 5. 6. 7.
Cash Flow versus Discount Rate Approaches to Cost of Capital Measurement Recommended Framework Comparison of Methods Conversion of Cash Flows Project Specific Adjustments Conclusions

1. Cash Flow vs. Discount Rate
Basic Project Evaluation:

Forecast nominal cash flows Currency choice (assume US$) Decide what risks will be reflected in cash flows and those in the discount rate
Beware of double discounting

Simple example:
Assume a simple project with expected $100 in perpetual cash flows If located in the U.S., the discount rate would be 10% and
Value= $100/0.10= $1,000

Simple example:
However, project is not located in the U.S. but a risky country If we reflect the country risk in the discount rate, the rate rises to 20%
Value = $100/0.20 = $500

Simple example:
If we reflect the country risk in the cash flows, the value is identical
Value = $50/0.10 = $500

Our approach
We will propose methods that deliver discount rates that reflect country risk. As our example showed, it is a simple matter of shifting the country risk from the discount rate to the cash flows.

Our approach
Indeed, we will often do this.
That is, we will use quantitative methods to get a measurement of country risk in the discount rate. Use the country risk adjustment in the cash flows (and adjust discount rate down accordingly). Use Monte Carlo methods on cash flows rather than cash flows and discount rate.

2. International Cost of Capital
Many different approaches:

1. Identical Cost of Capital (all locations) 2. World CAPM or Multifactor Model (SharpeRoss) 3. Segmented/Integrated (Bekaert-Harvey) 4. Bayesian (Ibbotson Associates) 5. Country Risk Rating (Erb-Harvey-Viskanta) 6. CAPM with Skewness (Harvey-Siddique)

7. Goldman-integrated sovereign yield spread model 8. Goldman-segmented 9. Goldman-EHV hybrid 10. CSFB volatility ratio model 11. CSFB-EHV hybrid 12. Damoradan

Identical Cost of Capital

Ignores the fact that shareholders require different expected returns for different risks

Identical Cost of Capital

Risky investments get evaluated with too low of a discount rate (and look better than they should) Less risky investments get evaluated with too high of a discount rate (and look worse than they are) Hence, method destroys value Avoid

World CAPM
Sharpes Capital Asset Pricing Model is the mainstay of economic valuation Simple formula Intuition is that required rate of return depends on how the investment contributes to the volatility of a well diversified portfolio

World CAPM
Expected discount rate (in U.S. dollars) on investment that has average in a country = riskfree + FM x world risk premium Beta is measured relative to a world portfolio OK for developed markets if we allow risk to change through time (Harvey 1991)

World CAPM
Strong assumptions needed Perfect market integration Mean-variance analysis implied by utility assumptions Fails in emerging markets

Returns and Beta from 1970
0.5 Average returns 0.4 0.3 0.2 0.1 0 -0.5 -0.1 0 0.5 1 Beta 1.5 2 2.5 3 R2 = 0.013
Should be a positive relation, with higher risk associated with higher return! But perhaps we should look at a more recent sample of data.

Returns and Beta from 1990
0.5 Average returns 0.4 0.3 0.2 0.1 0 -0.5 -0.1 0 0.5 1 Beta 1.5 2 2.5 3 R = 0.0211
2
Still goes the wrong way - even with data from 1990!

World CAPM
OK to use in developed markets May give unreliable results in smaller, less liquid developed markets

Segmented/Integrated CAPM
CAPM assumes that markets are perfectly integrated
foreign investors can freely invest in the local market local investors can freely invest outside the local market
Many markets are not integrated so we need to modify the CAPM

Bekaert and Harvey (1995) If market integrated, world CAPM holds If market segmented, local CAPM holds If going through the process of integration, a combination of two holds

Estimate world beta and expected return = riskfree + FMw x world risk premium Estimate local beta and expected return = local riskfree + FML x local risk premium

Put everything in common currency terms Add up the two components. CC= w[world CC] + (1-w)[local CC] Weights, w, determined by variables that proxy for degree of integration, like size of trade sector and equity market capitalization to GDP

Weights are dynamic, as are the risk loadings and the risk premiums Downside: hard to implement; only appropriate for countries with equity markets Recommendation: Wait

Ibbotson Associates
(Recognized expert in cost of capital calculation)
Approach recognizes that the world CAPM is not the best model Ibbotson approach combines the CAPMs prediction with nave prediction based on past performance.

Ibbotson Associates
STEPS 1 Calculate world risk premium=U.S. risk premium divided by the beta versus the MSCI world 2 Estimate country beta versus world index 3 Multiply this beta times world risk premium

Ibbotson Associates
4 Add in 0.5 times the intercept from the initial regression. This additional premium represents the compensation an investor receives for taking on the considerable risks of the emerging markets that is not explained by beta alone.

Ibbotson Associates
Gives unreasonable results in some countries Only useful if equity markets exist Ibbotson Associates does not even use it Recommendation: Do not use this version. Ibbotson has alternative methods available.

CAPM with Skewness

For years, economists did not understand why people spend money on lottery tickets and horse betting The expected return is negative and the volatility is high Behavioral explanations focused on risk loving

CAPM with Skewness

But this is just preference for positive skewness (big positive outcomes) People like positive skewness and dislike negative skewness (downside)

CAPM with Skewness

Most are willing to pay extra for an investment that adds positive skewness (lower hurdle rate), e.g. investing in a startup with unproven technology

CAPM with Skewness

Harvey and Siddique (2000) tests of a model that includes time-varying skewness risk Bekaert, Erb, Harvey and Viskanta detail the implications of skewness and kurtosis in emerging market stock selection

CAPM with Skewness

Model still being developed Skewness similar to many real options that are important in project evaluation Recommendation: Wait

Goldman-Integrated*
This model is widely used by McKinsey, Salomon and many others. Addresses the problem that the CAPM gives a discount rate too low. Solution: Add the sovereign yield spread
*J.O. Mariscal and R. M. Lee, The valuation of Mexican Stocks: An extension of the capital asset pricing model to emerging markets, Goldman Sachs, June 18, 1993.

Goldman-Integrated
The sovereign yield spread is the yield on a U.S. dollar bond that a country offers versus a U.S. Treasury bond of the same maturity The spread is said to reflect country risk

Goldman-Integrated
STEPS Estimate market beta on the S&P 500 Beta times historical US premium Add sovereign yield spread plus the risk free

Goldman-Integrated-EHV Hybrid
Goldman model only useful if you have sovereign yield spread Use Erb, Harvey and Viskanta model to fit ratings on yield spread

Real Yields and Institutional Investor Country Credit Ratings from 1990 through 1998:03
14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 0 20 40 Rating 60 Real Yields
R2 = 0.8784
80
100

You just need a credit rating (available for 136 countries now) and the EHV model will deliver the sovereign yield

Even adding this yield spread delivers a cost of capital that is unreasonably low in many countries While you can get the yield spread in 136 countries with the EHV method, you can only get risk premiums for those countries with equity markets

Goldman-Segmented
Main problem is the beta It is too low for many risky markets Solution: Increase the beta

Goldman-Segmented
Modified beta=standard deviation of local market return in US dollars divided by standard deviation of the US market return Beta times historical US premium Add sovereign yield spread

Goldman-Segmented Strange formulation. The usual beta is:

Betai ,World ! Correlationi ,World Std .devi v Std .devWorld
Using volatility ratio implies that the Correlation=1 !!

Goldman-Segmented
No economic foundation for modification No clear economic foundation for method in general Recommendation: Not recommended

CSFB E[ri]=SYi + Fi{E[rus-RFus] x Ai} x Ki

SYi = brady yield (use fitted from EHV) Fi = the beta of a stock against a local index
L. Hauptman and S. Natella, The cost of equity in Latin American, Credit Swisse First Boston, May 20, 1997.

CSFB E[ri]=SYi + Fi{E[rus-RFus] x Ai} x Ki

Ai =the coefficient of variation (CV) in the local market divided by the CV of the U.S. market) where CV = W/mean. Ki =constant term to adjust for the interdependence between the risk-free rate and the equity risk premium

CSFB
No economic foundation Complicated, nonintuitive and ad hoc Recommendation: Avoid

Damodaran Idea is to adjust the sovereign spread to make it more like an equity premium rather than a bond premium
A. Damodaran, Estimating equity risk premiums, working paper, NYU, undated.

Damodaran Country Sovereign Equity std. dev. equity = yield x -----------------premium spread Bond std. dev.

Damodaran Advantage: Recognizes that you just cant use the bond yield spread as a plug number in the CAPM Disadvantage: Assumes that Sharpe ratios for stocks and bonds must be the same in any particular country.

3. Recommended Framework
Country Risk Rating Model

Erb, Harvey and Viskanta (1995) Credit rating a good ex ante measure of risk Impressive fit to data
C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Journal of Portfolio Management, 1995.


Erb, Harvey and Viskanta (1995) Explore risk surrogates:
Political Risk, Economic Risk, Financial Risk and Country Credit Ratings

Country Risk Rating Model Sources

Political Risk Services International Country Risk Guide Institutional Investors Country Credit Rating Euromoneys Country Credit Rating Moodys S&P

3. Recommended Framework Political risk. International Country Risk Guide
% I P c Economic expectations vs. reality Economic planning failures Political leadership External conflict Corruption in government Military in politics Organized religion in politics Law and order tradition Racial and nationality tensions Political terrorism Civil war Political party development Quality of the Bureaucracy Total Political Points P s 12 12 12 10 6 6 6 6 6 6 6 6 6 100 I % ex C p s e 12% 6% 12% 6% 12% 6% 10% 5% 6% 3% 6% 3% 6% 3% 6% 3% 6% 3% 6% 3% 6% 3% 6% 3% 6% 3% 100% 50%

3. Recommended Framework Financial risk. International Country Risk Guide
Financial Loan Default or unfavorable loan restructuring Delayed payment of suppliers credits Repudiation of contracts by governments Losses from exchange controls Expropriation of private investments Total Financial Points
10 10 10 10 10 50
20% 20% 20% 20% 20% 100%
5% 5% 5% 5% 5% 25%

3. Recommended Framework Economic risk. International Country Risk Guide
Ec nomic 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 market indicators Total Economic Points Overall Points
10 10 5 5 15 5
20% 20% 10% 10% 30% 10%
5% 5% 3% 3% 8% 3% 25% 100%
50 100% 200
isk Analysis and Project Evaluation

3. ecommended Frame ork International Country Risk Guide Risk Categories
Risk ate Very igh igh isk oderate o isk Very o
or isk isk isk
omposite Score Ra ge 0.0-49.5 50.0-59.5 60.0-69.5 70.0-84.5 85.0-100.0

3. Recommended Framework Institutional Investors Country Credit Ratings
Economic Outlook Debt Service Financial Reserves/Current Account Fiscal Policy Political Outlook Access to Capital Markets Trade Balance Inflow of Portfolio Investment Foreign Direct Investment
OECD 1979 1994 1 1 5 2 2 3 9 3 6 4 7 8 4 5 6 7 8 9
Emerging Rest of World 1979 1994 1979 1994 2 3 3 4 1 1 1 1 4 4 4 3 9 3 7 5 8 6 7 2 9 5 8 6 6 2 8 5 7 9 6 2 9 5 8 7

3. Recommended Framework Ratings are correlated:
100 90 80 70 60 50 40 30 20 10 0
Inst t t na Invest r
&P
vere gn at ngs

100 90 80 70 60 50 40 30 20 10 0
Eur
ne
&P
vere gn at ngs

100 90 80 70 60 50 40 30 20 10 0
ICRG Compos te
S&P Sovere gn Rat ngs
NR

Risk Measure Changes IC GC IC GP IC GF IC G II CC II CC -0.03 0.01 0.03 -0.09 IC GC 0.35 0.79 0.54 0.43 0.30 0.83 0.25 0.06 IC GP 0.05 0.26 0.60 0.35 IC GF 0.10 0.52 0.24 0.25 IC G Risk Measure Levels
Risk Analysis and roject valuation

Recommended ramework ICRG ratings predict changes in II ratings:
Attribute Coefficient 1 ICRGC ICRG 1 ICRG ICRG
T-Stat
R-Square

3. Recommended Framework Ratings predict inflation:
1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0 20 40 60 80 100 II Rat ng September 1996 In at on e pectat ons or 1997

3. Recommended Framework Ratings correlated with wealth:
$25,000 Per cap ta rea GDP $20,000 $15,000 $10,000 $5,000 $0 0 20 40 60 80 100 II rat ngs or 74 countr es

3. Recommended Framework Time-series of ratings:
100 90 80 70 60 50 40 30 20 10 0
19 7 19 9 8 19 0 8 19 1 8 19 2 8 19 3 8 19 4 8 19 5 8 19 6 8 19 7 8 19 8 8 19 9 9 19 0 9 19 1 9 19 2 9 19 3 9 19 4 9 19 5 9 19 6 9 19 7 98
Switzer and
Ita y
Kuwait
rgentina

Returns and Institutional Investor Country Credit Ratings from 1990
0.5 Average returns 0.4 0.3 0.2 0.1 0 -0.1 0 20 40 Rating 60 80 100 R = 0.2976
2
Fit is as good as it gets - lower rating (higher risk) commands higher expected returns. Even in among US firms, our best model gets about 30% explanatory power.

Credit Rating Model

Intuitive Can be used in 136 countries, that is, in countries without equity markets Fits developed and emerging markets


STEPS: EVR = risk free + intercept - slope x Log(IICCR) Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating

3. Recommended Framework Easy to use:
70 60 Hurd e rate 50 40 30 20 10 0 0 10 20 30 40 50 60 70 80 90 Rating ICRGC IICCR:84 IICCR:79 100

3. Recommended Framework Also predicts volatility:
70% 60%
Annualized Volatilit
R = 0.5033
50% 40% 30% 20% 10% 0% 0 20 40 60 80 100

Institutional Investor Country Credit Rating

3. Recommended Framework Fitted volatility:
80 70 60 50 40 30 20 10 0
Expected volatility
10
20
30
40
50
60
70
80
90
Rating IICCR:84 IICCR:79
10

3. Recommended Framework And correlation.
100% 80% 60% 40% 20% 0% 0 -20%
Institutional Investor Countyr Credit Rating
R2 = 0.6809
Correlation with MSCI AC Wo
20
40
60
80
100

3. Recommended Framework Fitted correlation.
Expected correlation wit world 80 60 40 20 0 -20 -40 -60 -80 -100 Rating IICCR:84 IICCR:79
10
20
30
40
50
60
70
80
90
10
isk Ana ysis and Projec Eva ua ion

3. ecommended Frame ork Asian Crisis.
100 90 80 70 60 50 40 30 20 10 0
9 nJa 7 97 ar97 ya Ju 97 97 pSe 97 vo 9 nJa 8 98 ar98 ya Ju 98
ICRG rating
China Korea Singapore
ong Kong a aysia ai an
ndia Pakis an hai and
ndonesia Phi ippines ussia
isk Ana ysis and Project Eva uation

3. ecommended Framework Asian Crisis.
90 85 ICRG rating 80 75 70 65 60
-9 an J 7 7 r- 9 a 97 ya Ju 97 97 pSe 97 vo -9 an J 8 8 r- 9 a 98 ya Ju 98 98 pSe
Beginning of crisis
Korea
a aysia
ussia
k Analy
Value of US$100
200 180 160 140 120 100 80 60 40 20 0
9 nJa 7 a97 97 ya
and P oject Evaluat on
3. ecommended F amewo k
Beg nn ng of c
Value of $100
97 97 pulJ Se
97 vo
9 nJa
a-
98
98 ya
98 98 pulJ Se
Ko ea
alay a
i k Analy i and Project Evaluation

3. ecommended Framework Value of local currency
(indexed at 100)
120 100 Value of $100 80 60 40 20 0
-9 an J 7 7 r- 9 a 97 ya 97 97 pulJ Se 97 vo -9 an J 8 8 r- 9 a 98 ya 98 98 pulJ Se
Beginning of cri i
Korea
alay ia
u ia

September 11 impacted the way that business is conducted all over the world (cannot be diversified away) It is reasonable to expect that investors demand a premium to compensate them for new investment in ventures that are now deemed riskier.

S&P
1150 1130 1110 1090 1070 1050 1030 1010 990 970 950
3
September
September

S&P
1400 1350 1300 1250 1200 1150 1100 1050 1000 950
3
September

S&P 5
1680 1480 1280 1080 880 680 480 280 80
3 3 3 3 3 3 3
September
3 3 3 3 3

Impact not as substantial as one might think in advance. Nevertheless, risk increased. Initially, people thought more terror would be soon to come. As time elapsed, the probability of additional terror decreased.

ICRG Political Risk Rating
95.0 90.0 85.0 80.0 75.0 70.0 65.0 60.0 Nov-01 Jun-01 Jul-01 Jan-02 Feb-02 Apr-01 May-01 Dec-01 Aug-01 Sep-01 Mar-02 Oct-01 United States World

More impact on U.S. than average of other countries. Implies a small increase in the risk premium in the U.S. (10bp) and a smaller increase in world premium (2bp).

Graham-Harvey survey of the risk premium during September 11 crisis.

Pre Sept. 11 Post-Sept. 11 10-year premi m
ean premium isagreement volatility
3.63 2.36
4.82 3.03

4. Comparison of Methods
35.00%
68%
30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Argentina Me ico Thailand CA M Ibbotson EHV G -EHV G - eg C FB-EHV

537%
30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% lova ia a istan United tates
CA M Ibbotson EHV G -EHV G - eg C FB-EHV

Excel version

5. Conversion of Cash Flows
Forward Rate
Intuitive (expected exchange rate levels) Works fine for developed countries In emerging markets, there are two problems Data not readily available Will reflect a risk premium

Forward Rate
Risk premium in forward rate will lead to double discounting Think of the forward rate as the difference between two interest rates (local and U.S.). This difference will tell us something about inflation expectations But the local interest rate also reflects a default probability (sovereign risk)

Purchasing Power Parity

Simple theory: The exchange rate will depreciate by the difference in the local inflation rate and the U.S. inflation rate. Empirical evidence shows this assumption works well in emerging markets (but not that well in developed markets)

Purchasing Power Parity

To operationalize, we need multiyear forecasts of inflation in the particular country as well as the U.S. The difference in these rates is used to map out the expected exchange rates The expected exchange rates are used to convert cash flows into US$ We then apply the US$ discount rate to US$ cash flows

6. Project Specific Adjustments
Project Risk Analysis Operating Risk

Pre-completion Post-completion Sovereign
Financial Risk

Operating Risk Precompletion

Resources available (quality/quantity) Technological risk (proven technology?) Timing risks (failure to meet milestones) Completion risk
Handle in cash flows

Operating Risk Post-completion

Market risks (prices of outputs) Supply/input risk (availability) Throughput risk (material put through plus efficacy of systems operations) Operating cost
Handle in cash flows

Operating Risk Sovereign Risk (Macroeconomic)

Exchange rate changes Currency convertibility and transferability Inflation
Handle through discount rate

Operating Risk Sovereign Risk (Political/Legal)

Expropriation
Direct (seize assets) Diversion (seize project cash flows) Creeping (change taxation or royalty)
Legal system
May not be able to enforce property rights

Operating Risk Sovereign Risk (Force Majeure)

Political events
Wars Labor strikes Terrorism Changes in laws
Natural catastrophes
Hurricanes/earthquakes/floods

Financial Risks Probability of default

Look at debt service coverage ratios and leverage through life of project
Check to see if internal rate of return is consistent with (at least) the financial risks Handle through discount rate

Conclusions Project evaluation in developing countries is much more complex than in developed countries Critical to: accurately identify risks and to measure the degree of mitigation if any. Each risks need to be handle consistently either in the cash flows or the discount rate, not both.

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Project Appraisal and Risk Management (PARM) Duke Center for International Development at the Sanford Institute May

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Basic Project Evaluation:

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Many different approaches:

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Identical Cost of Capital

Risk Analysis and Project Evaluation

Identical Cost of Capital

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Many markets are not integrated so we need to modify the CAPM

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

CAPM with Skewness

Risk Analysis and Project Evaluation

CAPM with Skewness

Risk Analysis and Project Evaluation

CAPM with Skewness

Risk Analysis and Project Evaluation

CAPM with Skewness

Risk Analysis and Project Evaluation

CAPM with Skewness

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

Goldman-Segmented Strange formulation. The usual beta is:

Using volatility ratio implies that the Correlation=1 !!

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

CSFB E[ri]=SYi + Fi{E[rus-RFus] x Ai} x Ki

Risk Analysis and Project Evaluation

CSFB E[ri]=SYi + Fi{E[rus-RFus] x Ai} x Ki

Risk Analysis and Project Evaluation

Risk Analysis and Project Evaluation

A. Damodaran, Estimating equity risk premiums, working paper, NYU, undated.