Valuing Country Risk: Pictures Of Global Risk – Part II by Aswath Damodaran, Musings on Markets
In my last post, I looked at the determinants of country risk and attempts to measure that risk, by risk measurement services, ratings agencies and by markets. In this post, I would first like to focus on how investors and business people can incorporate that risk into their decision-making. In the process, I will argue that while it is easy to show that risk varies across countries, significant questions remain on how best to deal with that risk when making investment and valuation judgments.
Valuing Country Risk
If the value of an asset is the risk-adjusted present value of its expected cash flows, it stands to reason that cash flow claims in riskier countries should be worth less than otherwise cash flow claims in safer parts of the world. This common-sense principle, though, can be complicated in practice, because there are two ways in which country risk can flow through into value.
- Adjust expected cash flows: The first is to adjust the expected cash flows for the risk, bringing in the probability of an adverse event occurring and computing the resulting effect on cash flows. In effect, the expected cash flows on an investment will be lower in riskier countries than an otherwise similar investment in safer countries, though the mechanics of how we lower the cash flows has to be made explicit.
- Modify required return: The second is to augment the required return on your investment to reflect additional country risk. Thus, the discount rate you use for cash flows from an investment in Argentina will be higher than the discount rate that you use for cash flows in Germany, even if you compute the discount rate in the same currency (US dollars or Euros, for instance). The question of whether there should be an additional premium for exchange rate risk is surprisingly difficult to answer, though I will give it my best shot later in this post.
While both processes are used by analysts, the adjustments made to cash flows and discount rates are often arbitrary and risk is all too often double counted. The questions of which types of risks to bring into the expected cash flows and which ones into discount rates but also how to do so remain open and I will lay out my perspective in this post.
Adjust Cash Flows
If there is a probability that your business can be adversely impacted by risk in a country, it stands to reason that you should incorporate this effect into your expected cash flow. There are three ways that you can make this adjustment.
- Probabilistic adjustment: The first is to estimate the likelihood that a risky event will occur, the consequences for value and cash flow if it does and to compute an expected value. This is the best route to follow for discrete, country-specific risks that can have large or catastrophic effects on your business value, since discount rates don’t lend themselves easily to discrete risk adjustment and the fact that the risk is country-specific suggests that globally diversified investors may be able to diversify away some or much of the risk. A good example would be nationalization risk in a country prone to expropriating private businesses, where bringing in its likelihood will lower expected earnings in future periods and cash flows.
- Build in the cost of protection: The second approach is to estimate the cost of buying protection against the country risk in question and bring in that cost into your expected cash flows. Thus, if you could buy insurance against nationalization, you could reduce your expected earnings by that insurance cost and use those earnings as a basis for estimating cash flows. This approach is best suited to those risks that can be insured against either in the insurance or financial markets. It is also my preferred approach in dealing with corruption risk, which, as I have argued in a prior post, is more akin to an unofficial tax imposed on the company.
- Cash flow hair cuts: The third way to adjust for country risk is to lower expected cash flows in risky countries 10%, 20% or more, with the adjustment varying across countries (with bigger hair cuts for riskier countries) and analysts (with more risk averse analysts making larger cuts). The perils of this approach are numerous. The first is that it is not only arbitrary but it is also specific to the individual making it, causing it to vary from investment decision to decision and from analyst to analyst. The second is that, once made, the adjustment is hidden or implicit and subsequent decision makers may not be aware that it has already been made, resulting in multiple risk adjustments at different levels of the decision-making process.
A key distinction between the first approach (probabilistic) and the other two (building in cost of insuring risk or haircutting cash flows) is that taking into account the probability that your business could be adversely impacted by an event and adjusting the expected cash flows for the impact does not “risk adjust” the cash flows. You will attach the same value to a risky business as you would to a safe business with the same expected cash flows.
Adjust Required Returns
The second approach to dealing with country risk is to adjust discount rates, pushing up the required returns (and discount rates) for investments made in riskier countries. Those higher rates will push down value, thus accomplishing the same end result as lowering expected cash flows.
Fixed Cash Flow Claims (Fixed Income)
With fixed income claims (bonds, financial guarantees), this is easy enough to do, requiring an additional default spread (for country risk) in the desired interest rate, which, in turn, will lower value. In my last post on country risk, I looked at measures of sovereign default risk including sovereign ratings and credit default swaps. If you have a fixed cash flow claim against a sovereign, you could use these default risk measures to calculate the value of these claims. Thus, if the sovereign CDS spread for Brazil is 2.91% and the risk free rate in US dollars is 2.47%, you would price Brazilian dollar denominated bonds or fixed obligations to earn you 5.38%.
But what if your claim is against a company or business in a risky country? There are two ways in which you could estimate the default spread that you would use to value this claim:
- Company Rating: Just as ratings agencies and CDS markets estimate default risk in sovereigns, they also estimate default risk in some companies, especially larger ones. If your fixed cash flow claim is against a company where one or both of these are available, you can use them to compute an expected return (and discount your fixed claims at that rate). To illustrate, Vale, a Brazilian mining company, has a bond rating of Baa2 from Moody’s in July 2015, and the default spread for a Baa2 rated bond rated bond is 1.75%. Since ratings agencies already incorporate (at least in theory) the fact that Vale is a Brazilian company into the bond rating, there is no need to consider country risk.
US dollar cost of debt for Vale = US $ Risk free rate +