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• 1. Risk Analysis and Project Evaluation1 Wali Memon Wali Memon
• 2. Risk Analysis and Project Evaluation Plan 1. Cash Flow versus Discount Rate 2. Approaches to Cost of Capital Measurement 3. Recommended Framework 4. Comparison of Methods 5. Conversion of Cash Flows 6. Project Specific Adjustments 7. Conclusions2 Wali Memon
• 3. Risk Analysis and Project Evaluation 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 discounting3 Wali Memon
• 4. Risk Analysis and Project Evaluation 1. Cash Flow vs. Discount Rate 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= \$1,0004 Wali Memon
• 5. Risk Analysis and Project Evaluation 1. Cash Flow vs. Discount Rate 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 = \$5005 Wali Memon
• 6. Risk Analysis and Project Evaluation 1. Cash Flow vs. Discount Rate Simple example: If we reflect the country risk in the cash flows, the value is identical Value = \$50/0.10 = \$5006 Wali Memon
• 7. Risk Analysis and Project Evaluation 1. Cash Flow vs. Discount Rate 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.7 Wali Memon
• 8. Risk Analysis and Project Evaluation 1. Cash Flow vs. Discount Rate 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.8 Wali Memon
• 9. Risk Analysis and Project Evaluation 2. International Cost of Capital Many different approaches: 1. Identical Cost of Capital (all locations) 2. World CAPM or Multifactor Model (Sharpe- Ross) 3. Segmented/Integrated (Bekaert-Harvey) 4. Bayesian (Ibbotson Associates) 5. Country Risk Rating (Erb-Harvey-Viskanta) 6. CAPM with Skewness (Harvey-Siddique)9 Wali Memon
• 10. Risk Analysis and Project Evaluation 2. International Cost of Capital7. Goldman-integrated sovereign yield spread model8. Goldman-segmented9. Goldman-EHV hybrid10. CSFB volatility ratio model11. CSFB-EHV hybrid12. Damoradan10 Wali Memon
• 11. Risk Analysis and Project Evaluation 2. International Cost of Capital Identical Cost of Capital • Ignores the fact that shareholders require different expected returns for different risks11 Wali Memon
• 12. Risk Analysis and Project Evaluation 2. International Cost of CapitalIdentical 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 Avoid12 Wali Memon
• 13. Risk Analysis and Project Evaluation 2. International Cost of CapitalWorld CAPM• Sharpe’s 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 portfolio13 Wali Memon
• 14. Risk Analysis and Project Evaluation 2. International Cost of CapitalWorld CAPM• Expected discount rate (in U.S. dollars) on investment that has average in a country = riskfree + βι 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)14 Wali Memon
• 15. Risk Analysis and Project Evaluation 2. International Cost of CapitalWorld CAPM• Strong assumptions needed• Perfect market integration• Mean-variance analysis implied by utility assumptions• Fails in emerging markets15 Wali Memon
• 16. Risk Analysis and Project Evaluation 2. International Cost of Capital Returns and Beta from 1970 0.5 0.4 2Average returns R = 0.013 0.3 0.2 0.1 0 -0.5 -0.1 0 0.5 1 1.5 2 2.5 3 Beta Should be a positive relation, with higher risk associated with higher return! But perhaps we should look at a more recent sample 16 data. Wali Memon of
• 17. Risk Analysis and Project Evaluation 2. International Cost of Capital Returns and Beta from 1990 0.5 0.4 Average returns 2 0.3 R = 0.0211 0.2 0.1 0 -0.5 -0.1 0 0.5 1 1.5 2 2.5 3 Beta17 Still goes the wrong way - even with data from 1990! Wali Memon
• 18. Risk Analysis and Project Evaluation 2. International Cost of CapitalWorld CAPM• OK to use in developed markets• May give unreliable results in smaller, less liquid developed markets18 Wali Memon
• 19. Risk Analysis and Project Evaluation 2. International Cost of CapitalSegmented/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 CAPM19 Wali Memon
• 20. Risk Analysis and Project Evaluation 2. International Cost of CapitalSegmented/Integrated 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 holds20 Wali Memon
• 21. Risk Analysis and Project Evaluation 2. International Cost of CapitalSegmented/Integrated CAPMEstimate world beta and expected return= riskfree + βιw x world risk premiumEstimate local beta and expected return= local riskfree + βιL x local risk premium21 Wali Memon
• 22. Risk Analysis and Project Evaluation 2. International Cost of CapitalSegmented/Integrated CAPM• 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 and22 equity market capitalization to GDP Wali Memon
• 23. Risk Analysis and Project Evaluation 2. International Cost of CapitalSegmented/Integrated CAPM• Weights are dynamic, as are the risk loadings and the risk premiums• Downside: hard to implement; only appropriate for countries with equity markets• Recommendation: Wait23 Wali Memon
• 24. Risk Analysis and Project Evaluation 2. International Cost of CapitalIbbotson Associates(Recognized expert in cost of capital calculation)• Approach recognizes that the world CAPM is not the best model• Ibbotson approach combines the CAPM’s prediction with naïve prediction based on past performance.24 Wali Memon
• 25. Risk Analysis and Project Evaluation 2. International Cost of CapitalIbbotson Associates• STEPS1 Calculate world risk premium=U.S. risk premium divided by the beta versus the MSCI world2 Estimate country beta versus world index3 Multiply this beta times world risk premium25 Wali Memon
• 26. Risk Analysis and Project Evaluation 2. International Cost of CapitalIbbotson Associates4 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.”26 Wali Memon
• 27. Risk Analysis and Project Evaluation 2. International Cost of CapitalIbbotson 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.27 Wali Memon
• 28. Risk Analysis and Project Evaluation 2. International Cost of CapitalCAPM 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”28 Wali Memon
• 29. Risk Analysis and Project Evaluation 2. International Cost of CapitalCAPM with Skewness• But this is just preference for positive skewness (big positive outcomes)• People like positive skewness and dislike negative skewness (downside)29 Wali Memon
• 30. Risk Analysis and Project Evaluation 2. International Cost of CapitalCAPM 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 technology30 Wali Memon
• 31. Risk Analysis and Project Evaluation 2. International Cost of CapitalCAPM 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 selection31 Wali Memon
• 32. Risk Analysis and Project Evaluation 2. International Cost of CapitalCAPM with Skewness• Model still being developed• Skewness similar to many “real options” that are important in project evaluation Recommendation: Wait32 Wali Memon
• 33. Risk Analysis and Project Evaluation 2. International Cost of Capital 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 33asset pricing model to emerging markets, Goldman Sachs, June 18, 1993. Wali Memon
• 34. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-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”34 Wali Memon
• 35. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-IntegratedSTEPS• Estimate market beta on the S&P 500• Beta times historical US premium• Add sovereign yield spread plus the risk free35 Wali Memon
• 36. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-Integrated-EHV Hybrid• Goldman model only useful if you have sovereign yield spread• Use Erb, Harvey and Viskanta model to fit ratings on yield spread36 Wali Memon
• 37. Risk Analysis and Project Evaluation 2. International Cost of Capital Real Yields and Institutional Investor Country Credit Ratings from 1990 through 1998:03 14.00% 12.00% Real Yields 10.00% 8.00% 2 R = 0.8784 6.00% 4.00% 2.00% 0.00% 0 20 40 60 80 100 Rating37 Wali Memon
• 38. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-Integrated-EHV Hybrid• You just need a credit rating (available for 136 countries now) and the EHV model will deliver the sovereign yield38 Wali Memon
• 39. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-Integrated-EHV Hybrid• 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 markets39 Wali Memon
• 40. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-Segmented• Main problem is the beta• It is too low for many risky markets• Solution: Increase the beta40 Wali Memon
• 41. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-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 spread41 Wali Memon
• 42. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-Segmented• Strange formulation. The usual beta is: Std .devi Betai ,World = Correlationi ,World × Std .devWorld • Using volatility ratio implies that the42 Correlation=1 !! Wali Memon
• 43. Risk Analysis and Project Evaluation 2. International Cost of CapitalGoldman-Segmented• No economic foundation for modification• No clear economic foundation for method in general Recommendation: Not recommended43 Wali Memon
• 44. Risk Analysis and Project Evaluation 2. International Cost of Capital CSFB E[ri]=SYi + βi{E[rus-RFus] x Ai} x Ki • SYi = brady yield (use fitted from EHV) • βi = the beta of a stock against a local index44 Wali MemonL. Hauptman and S. Natella, The cost of equity in Latin American, Credit Swisse FirstBoston, May 20, 1997.
• 45. Risk Analysis and Project Evaluation 2. International Cost of CapitalCSFBE[ri]=SYi + βi{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 = σ/mean. • Ki =“constant term to adjust for the interdependence between the risk-free rate and the45 equity risk premium” Wali Memon
• 46. Risk Analysis and Project Evaluation 2. International Cost of CapitalCSFB• No economic foundation• Complicated, nonintuitive and ad hoc Recommendation: Avoid46 Wali Memon
• 47. Risk Analysis and Project Evaluation 2. International Cost of Capital Damodaran • Idea is to adjust the sovereign spread to make it more like an equity premium rather than a bond premiumA. Damodaran, Estimating equity risk premiums, working paper, NYU, undated. 47 Wali Memon
• 48. Risk Analysis and Project Evaluation 2. International Cost of CapitalDamodaranCountry Sovereign Equity std. dev. equity = yield x ------------------premium spread Bond std. dev.48 Wali Memon
• 49. Risk Analysis and Project Evaluation 2. International Cost of CapitalDamodaran• Advantage: Recognizes that you just can’t 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.49 Wali Memon
• 50. Risk Analysis and Project Evaluation 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 50C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Wali MemonJournal of Portfolio Management, 1995.
• 51. Risk Analysis and Project Evaluation 3. Recommended FrameworkCountry Risk Rating Model• Erb, Harvey and Viskanta (1995)• Explore risk surrogates: – Political Risk, – Economic Risk, – Financial Risk and – Country Credit Ratings51 Wali Memon
• 52. Risk Analysis and Project Evaluation 3. Recommended FrameworkCountry Risk Rating ModelSources• Political Risk Services’ International Country Risk Guide• Institutional Investor’s Country Credit Rating• Euromoney’s Country Credit Rating• Moody’s• S&P52 Wali Memon
• 53. Risk Analysis and Project Evaluation 3. Recommended Framework Political risk. International Country Risk Guide % of Individual % of Political Points Index Composite Economic expectations vs. reality 12 12% 6% Economic planning failures 12 12% 6% Political leadership 12 12% 6% External conflict 10 10% 5% Corruption in government 6 6% 3% Military in politics 6 6% 3% Organized religion in politics 6 6% 3% Law and order tradition 6 6% 3% Racial and nationality tensions 6 6% 3% Political terrorism 6 6% 3% Civil war 6 6% 3% Political party development 6 6% 3% Quality of the Bureaucracy 6 6% 3%53 Wali Memon Total Political Points 100 100% 50%
• 54. Risk Analysis and Project Evaluation 3. Recommended Framework Financial risk. International Country Risk Guide Financial Loan Default or unfavorable loan restructuring 10 20% 5% Delayed payment of suppliers’ credits 10 20% 5% Repudiation of contracts by governments 10 20% 5% Losses from exchange controls 10 20% 5% Expropriation of private investments 10 20% 5% Total Financial Points 50 100% 25%54 Wali Memon
• 55. Risk Analysis and Project Evaluation 3. Recommended Framework Economic risk. International Country Risk Guide Economic Inflation 10 20% 5% Debt service as a % of exports of goods and services 10 20% 5% International liquidity ratios 5 10% 3% Foreign trade collection experience 5 10% 3% Current account balance as a % of goods and services 15 30% 8% Parallel foreign exchange rate market indicators 5 10% 3% Total Economic Points 50 100% 25%55 Wali Memon Overall Points 200 100%
• 56. Risk Analysis and Project Evaluation 3. Recommended Framework International Country Risk Guide Risk Categories Risk Category Composite Score Range Very High Risk 0.0-49.5 High Risk 50.0-59.5 Moderate Risk 60.0-69.5 Low Risk 70.0-84.5 Very Low Risk 85.0-100.056 Wali Memon
• 57. Risk Analysis and Project Evaluation 3. Recommended Framework Institutional Investor’s Country Credit Ratings OECD Emerging Rest of World 1979 1994 1979 1994 1979 1994 Economic Outlook 1 1 2 3 3 4 Debt Service 5 2 1 1 1 1 Financial Reserves/Current 2 3 4 4 4 3 Account Fiscal Policy 9 4 9 7 6 6 Political Outlook 3 5 3 2 2 2 Access to Capital Markets 6 6 7 9 8 9 Trade Balance 4 7 5 5 5 5 Inflow of Portfolio Investment 7 8 8 8 7 8 Foreign Direct Investment 8 9 6 6 9 757 Wali Memon
• 58. Risk Analysis and Project Evaluation 3. Recommended Framework Ratings are correlated: 100 90 Institutional Investor CCR 80 70 60 50 40 30 20 10 0 AA+ AA- A BBB+ BBB- BB B+ NR58 Wali Memon S&P Sovereign Ratings
• 59. Risk Analysis and Project Evaluation 3. Recommended Framework Ratings are correlated: 100 90 80 Euromoney CCR 70 60 50 40 30 20 10 0 AA+ AA- A BBB+ BBB- BB B+ NR59 Wali Memon S&P Sovereign Ratings
• 60. Risk Analysis and Project Evaluation 3. Recommended Framework Ratings are correlated: 100 90 80 ICRG Composite 70 60 50 40 30 20 10 0 AA+ AA- A BBB+ BBB- BB B+ NR60 Wali Memon S&P Sovereign Ratings
• 61. Risk Analysis and Project Evaluation 3. Recommended Framework Ratings are correlated: Risk Measure Changes II CCR ICRGC ICRGP ICRGF ICRGE II CCR -0.03 0.01 0.03 -0.09 ICRGC 0.35 0.79 0.54 0.43 ICRGP 0.30 0.83 0.25 0.06 ICRGF 0.26 0.60 0.35 0.05 ICRGE 0.10 0.52 0.24 0.25 Risk Measure Levels61 Wali Memon
• 62. Risk Analysis and Project Evaluation 3. Recommended Framework ICRG ratings predict changes in II ratings: Attribute Coefficient T-Stat R-Square ICRGC 0.2120 7.59 5.0% ICRGP 0.1244 5.67 2.8% ICRGF 0.0956 5.69 2.8% ICRGE 0.0833 4.65 1.9%62 Wali Memon
• 63. Risk Analysis and Project Evaluation 3. Recommended Framework Ratings predict inflation: 1 Inflation expectations for 1997 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0 20 40 60 80 10063 Wali Memon II Rating September 1996
• 64. Risk Analysis and Project Evaluation 3. Recommended Framework Ratings correlated with wealth: \$25,000 \$20,000 Per capita real GDP \$15,000 \$10,000 \$5,000 \$0 0 20 40 60 80 10064 Wali Memon II ratings for 74 countries
• 65. Risk Analysis and Project Evaluation 3. Recommended Framework Time-series of ratings: 100 90 80 70 60 50 40 30 20 10 0 19 9 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 19 8 19 9 19 0 19 1 19 2 19 3 19 4 19 5 19 6 19 7 98 7 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 1965 Wali Memon Switzerland Italy Kuwait Argentina
• 66. Risk Analysis and Project Evaluation 3. Recommended Framework Returns and Institutional Investor Country Credit Ratings from 1990 0.5 0.4 Average returns 2 0.3 R = 0.2976 0.2 0.1 0 -0.1 0 20 40 60 80 100 Rating66 Fit is as good as it gets - lower rating (higher risk) commands higher Wali Memon expected returns. Even in among US firms, our best model gets about 30% explanatory power.
• 67. Risk Analysis and Project Evaluation 3. Recommended FrameworkCredit Rating Model• Intuitive• Can be used in 136 countries, that is, in countries without equity markets• Fits developed and emerging markets67 Wali Memon
• 68. Risk Analysis and Project Evaluation 3. Recommended FrameworkCountry Risk Rating ModelSTEPS:EVR = risk free + intercept - slope x Log(IICCR)• Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating68 Wali Memon
• 69. Risk Analysis and Project Evaluation 3. Recommended Framework Easy to use: 70% 60% 50% Hurdle rate 40% 30% 20% 10% 0% 0 0 10 20 30 40 50 60 70 80 90 10 Rating69 Wali Memon ICRGC IICCR:84 IICCR:79
• 70. Risk Analysis and Project Evaluation 3. Recommended Framework Also predicts volatility: 70% 60% 2 R = 0.5033 Annualized Volatility 50% 40% 30% 20% 10% 0% 0 20 40 60 80 10070 Wali Memon Institutional Investor Country Credit Rating
• 71. Risk Analysis and Project Evaluation 3. Recommended Framework Fitted volatility: 80% 70% Expected volatility 60% 50% 40% 30% 20% 10% 0% 0 0 10 20 30 40 50 60 70 80 90 10 Rating71 Wali Memon IICCR:84 IICCR:79
• 72. Risk Analysis and Project Evaluation 3. Recommended Framework And correlation. 100% 2 R = 0.6809 80% Correlation with MSCI AC World 60% 40% 20% 0% 0 20 40 60 80 100 -20% Institutional Investor Countyr Credit Rating72 Wali Memon
• 73. Risk Analysis and Project Evaluation 3. Recommended Framework Fitted correlation. 80% Expected correlation with world 60% 40% 20% 0% -20% 0 10 20 30 40 50 60 70 80 90 0 10 -40% -60% -80% -100% Rating73 Wali Memon IICCR:84 IICCR:79
• 74. Risk Analysis and Project Evaluation 3. Recommended Framework Asian Crisis. 100 80 ICRG rating 60 40 20 0 97 7 97 7 97 97 98 8 98 8 n- r -9 y- -9 p- v- n- r -9 y- -9 Ja a a ul a a ul M M J Se No Ja M M J China Hong Kong India Indonesia Korea Malaysia Pakistan Philippines74 Wali Memon Singapore Taiwan Thailand Russia
• 75. Risk Analysis and Project Evaluation 3. Recommended Framework Asian Crisis. Beginning of 90 crisis 85 ICRG rating 80 75 70 65 60 7 7 7 7 7 7 8 8 8 8 8 -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 Jan ar ay Jul ep ov Jan ar ay Ju l ep M M S N M M S75 Wali Memon Korea Malaysia Russia
• 76. Risk Analysis and Project Evaluation 3. Recommended Framework Value of US\$100 Beginning of 200 crisis 180 160 140 Value of \$100 120 100 80 60 40 20 0 7 7 7 7 7 7 8 8 8 8 8 -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 Jan ar ay Jul ep ov Jan ar ay Ju l ep M M S N M M S76 Wali Memon Korea Malaysia Russia
• 77. Risk Analysis and Project Evaluation 3. Recommended Framework Value of local currency (indexed at 100) Beginning of 120 crisis 100 Value of \$100 80 60 40 20 0 7 7 7 7 7 7 8 8 8 8 8 -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 -9 Jan ar ay Jul ep ov Jan ar ay Ju l ep M M S N M M S77 Wali Memon Korea Malaysia Russia
• 78. Risk Analysis and Project Evaluation 3. Recommended Framework • 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.78 Wali Memon
• 79. Risk Analysis and Project Evaluation 3. Recommended Framework S&P 500 September 2001 1150 1130 September 11 1110 1090 1070 1050 1030 1010 990 970 950 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 9/2 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 /0 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 2179 Wali Memon
• 80. Risk Analysis and Project Evaluation 3. Recommended Framework S&P 500 2001 1400 1350 1300 1250 September 2001 1200 1150 1100 1050 1000 950 1 1 1 1 1 1 1 1 1 1 1 1 0 00 00 00 00 00 00 00 00 00 00 00 20 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 /2 1/ 2 3 4 5 6 7 8 9 0 1 2 /0 /0 /0 /0 /0 /0 /0 /0 /0 /1 /1 /1 02 02 02 02 02 02 02 02 02 02 02 0280 Wali Memon
• 81. Risk Analysis and Project Evaluation 3. Recommended Framework S&P 500 1980-2002 1680 1480 1280 1080 880 680 480 280 September 2001 80 0 98 82 84 86 88 90 92 94 96 98 00 02 /1 /19 /19 /19 /19 /19 /19 /19 /19 /19 /20 /20 1 01 01 01 01 01 01 01 01 01 01 01 /0 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 31 3 3 3 3 3 3 3 3 3 3 381 Wali Memon
• 82. Risk Analysis and Project Evaluation 3. Recommended Framework• 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.82 Wali Memon
• 83. Risk Analysis and Project Evaluation 3. Recommended Framework ICRG Political Risk Rating 95.0 90.0 85.0 80.0 United States 75.0 World 70.0 65.0 60.0 Nov-01 Jul-01 Jun-01 Jan-02 Apr-01 May-01 Aug-01 Sep-01 Oct-01 Dec-01 Feb-0283 Wali Memon Mar-02
• 84. Risk Analysis and Project Evaluation 3. Recommended Framework • 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).84 Wali Memon
• 85. Risk Analysis and Project Evaluation 3. Recommended Framework • Graham-Harvey survey of the risk premium during September 11 crisis.85 Wali Memon
• 86. Risk Analysis and Project Evaluation 3. Recommended Framework Pre-Sept. 11 Post-Sept. 1110-year premiumMean premium 3.63 4.82Disagreement volatility 2.36 3.03 86 Wali Memon
• 87. Risk Analysis and Project Evaluation4. Comparison of Methods35.00% 68%30.00%25.00% CAPM20.00% Ibbotson EHV15.00% GS-EHV10.00% GS-Seg CSFB-EHV 5.00% 0.00% Argentina Mexico Thailand Wali Memon 87
• 88. Risk Analysis and Project Evaluation 4. Comparison of Methods 537% 30.00% 25.00% 20.00% 15.00% CAPM 10.00% Ibbotson 5.00% EHV 0.00% GS-EHV -5.00% GS-Seg -10.00% CSFB-EHV -15.00% -20.00% Slovakia Pakistan United States88 Wali Memon
• 89. Risk Analysis and Project Evaluation Excel version 4. Comparison of Methods89 Wali Memon
• 90. Risk Analysis and Project Evaluation 5. Conversion of Cash FlowsForward 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 premium90 Wali Memon
• 91. Risk Analysis and Project Evaluation 5. Conversion of Cash FlowsForward 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 default91 probability (sovereign risk) Wali Memon
• 92. Risk Analysis and Project Evaluation 5. Conversion of Cash FlowsPurchasing 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)92 Wali Memon
• 93. Risk Analysis and Project Evaluation 5. Conversion of Cash FlowsPurchasing 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\$93 We then apply the US\$ discount rate to US\$ cash • Wali Memon flows
• 94. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsProject Risk Analysis• Operating Risk – Pre-completion – Post-completion – Sovereign• Financial Risk94 Wali Memon
• 95. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsOperating Risk• Precompletion – Resources available (quality/quantity) – Technological risk (proven technology?) – Timing risks (failure to meet milestones) – Completion riskHandle in cash flows95 Wali Memon
• 96. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsOperating Risk• Post-completion – Market risks (prices of outputs) – Supply/input risk (availability) – Throughput risk (material put through plus efficacy of systems operations) – Operating costHandle in cash flows96 Wali Memon
• 97. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsOperating Risk• Sovereign Risk (Macroeconomic) – Exchange rate changes – Currency convertibility and transferability – InflationHandle through discount rate97 Wali Memon
• 98. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsOperating 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 rights98Handle through discount rate Wali Memon
• 99. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsOperating Risk• Sovereign Risk (Force Majeure) – Political events • Wars • Labor strikes • Terrorism • Changes in laws – Natural catastrophes • Hurricanes/earthquakes/floods99Handle through discount rate Wali Memon
• 100. Risk Analysis and Project Evaluation 6. Project Specific AdjustmentsFinancial 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 risksHandle through discount rate100 Wali Memon
• 101. Risk Analysis and Project Evaluation 6. Project Specific Adjustments 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,101 not both. Wali Memon