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PM40 Risk Analysis And

PM40 Risk Analysis And

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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

Risk Analysis and Project Evaluation
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

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 discounting

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= $1,000

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 = $500

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 = $500

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.

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.

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 (SharpeRoss) 3. Segmented/Integrated (Bekaert-Harvey) 4. Bayesian (Ibbotson Associates) 5. Country Risk Rating (Erb-Harvey-Viskanta) 6. CAPM with Skewness (Harvey-Siddique)

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

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 risks

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

World 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 portfolio

Risk Analysis and Project Evaluation
2. International Cost of Capital

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 ³world´ portfolio ‡ OK for developed markets if we allow risk to change through time (Harvey 1991)

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital
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.

Risk Analysis and Project Evaluation
2. International Cost of Capital
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!

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

Segmented/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 holds

Risk Analysis and Project Evaluation
2. International Cost of Capital

Segmented/Integrated CAPM
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

Risk Analysis and Project Evaluation
2. International Cost of Capital

Segmented/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 and equity market capitalization to GDP

Risk Analysis and Project Evaluation
2. International Cost of Capital

Segmented/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: Wait

Risk Analysis and Project Evaluation
2. International Cost of Capital

Ibbotson 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.

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

Ibbotson Associates
4 Add in 0.5 times the µintercept¶ from the initial regression. ³This 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.´

Risk Analysis and Project Evaluation
2. International Cost of Capital

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.

Risk Analysis and Project Evaluation
2. International Cost of Capital

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 ³risk loving´

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

CAPM with Skewness
‡ Model still being developed ‡ Skewness similar to many ³real options´ that are important in project evaluation Recommendation: Wait

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 asset pricing model to emerging markets, Goldman Sachs, June 18, 1993.

Risk Analysis and Project Evaluation
2. International Cost of Capital

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 ³country risk´

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

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% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 0 20 40 Rating 60 Real Yields

R2 = 0.8784

80

100

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

Goldman-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 markets

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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 !!

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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.

Risk Analysis and Project Evaluation
2. International Cost of Capital

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 =³constant term to adjust for the interdependence between the risk-free rate and the equity risk premium´

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

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 premium

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

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

Risk Analysis and Project Evaluation
2. International Cost of Capital

Damodaran ‡ 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.

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

C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Journal of Portfolio Management, 1995.

Risk Analysis and Project Evaluation
3. Recommended Framework

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

Risk Analysis and Project Evaluation
3. Recommended Framework

Country Risk Rating Model Sources
‡ ‡ ‡ ‡ ‡ Political Risk Services¶ International Country Risk Guide Institutional Investor¶s Country Credit Rating Euromoney¶s Country Credit Rating Moody¶s S&P

Risk Analysis and Project Evaluation
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%

Risk Analysis and Project Evaluation
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%

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
3. Recommended Framework Institutional Investor¶s 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

Risk Analysis and Project Evaluation
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

N

Risk Analysis and Project Evaluation
3. Recommended Framework Ratings are correlated:
100 90 80 70 60 50 40 30 20 10 0

Eur

ne

-

-

-

+

+

+

+

-

+

&P

vere gn at ngs

N

Risk Analysis and Project Evaluation
3. Recommended Framework Ratings are correlated:
100 90 80 70 60 50 40 30 20 10 0

ICRG Compos te

-

-

-

+

+

+

+

-

+

S&P Sovere gn Rat ngs

NR

Risk Analysis and Project Evaluation
3. Recommended Framework Ratings are correlated:

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

1

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
3. Recommended Framework
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.

Risk Analysis and Project Evaluation
3. Recommended Framework

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

Risk Analysis and Project Evaluation
3. Recommended Framework

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

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
3. Recommended Framework Also predicts volatility:
70% 60%
Annualized Volatilit

R = 0.5033

2

50% 40% 30% 20% 10% 0% 0 20 40 60 80 100
Institutional Investor Country Credit Rating

Risk Analysis and Project Evaluation
3. Recommended Framework Fitted volatility:
80 70 60 50 40 30 20 10 0

Expected volatility

0

10

20

30

40

50

60

70

80

90

Rating IICCR:84 IICCR:79

10

0

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
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

0

10

0

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

8

a-

98

98 ya

98 98 pulJ Se

Ko ea

alay a

u

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

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.

Risk Analysis and Project Evaluation
3. Recommended Framework

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

September
September

3

Risk Analysis and Project Evaluation
3. Recommended Framework

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

September

Risk Analysis and Project Evaluation
3. Recommended Framework

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

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.

Risk Analysis and Project Evaluation
3. Recommended Framework
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

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).

Risk Analysis and Project Evaluation
3. Recommended Framework

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

Risk Analysis and Project Evaluation
3. Recommended Framework

Pre Sept. 11 Post-Sept. 11 10-year premi m

ean premium isagreement volatility

3.63 2.36

4.82 3.03

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
4. Comparison of Methods
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

Risk Analysis and Project Evaluation
Excel version

4. Comparison of Methods

Risk Analysis and Project Evaluation
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

Risk Analysis and Project Evaluation
5. Conversion of Cash Flows

Forward Rate
‡ Risk premium in forward rate will lead to ³double 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)

Risk Analysis and Project Evaluation
5. Conversion of Cash Flows

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)

Risk Analysis and Project Evaluation
5. Conversion of Cash Flows

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

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

Project Risk Analysis ‡ Operating Risk
± Pre-completion ± Post-completion ± Sovereign

‡ Financial Risk

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

Operating Risk ‡ Precompletion
± Resources available (quality/quantity) ± Technological risk (proven technology?) ± Timing risks (failure to meet milestones) ± Completion risk

Handle in cash flows

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

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

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

Operating Risk ‡ Sovereign Risk (Macroeconomic)
± Exchange rate changes ± Currency convertibility and transferability ± Inflation

Handle through discount rate

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

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

Handle through discount rate

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

Operating Risk ‡ Sovereign Risk (Force Majeure)
± Political events
‡ ‡ ‡ ‡ Wars Labor strikes Terrorism Changes in laws

± Natural catastrophes
‡ Hurricanes/earthquakes/floods

Handle through discount rate

Risk Analysis and Project Evaluation
6. Project Specific Adjustments

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

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, not both.

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