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Valuation and Financial Forensics

Educate, Communicate, Preserve


NACVA and IBAs Annual Consultants Conference
Stock Market Analysis
and Risk Premium Estimation
International Track
and
Anamaria Ciobanu, PhD
present
May 27-30, 2009
Boston, MA
Stock Market Analysis
and Risk Premium Estimation
Anamaria Ciobanu, PhD
Picture needed
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Stock Market Analysis
and Risk Premium Estimation
Give me a place to stand on, and I will
move the Earth
Archimedes
Sometimes your best investments are the
ones you don't make.
Donald Trump
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RISK RETURN
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Types of Equity Premiums*
Historical Equity Premium
Expected Equity Premium
Required Equity Premium
Implied Equity Premium
Which one should we consider in order to
estimate the discount rate (cost of capital)?
* Classification proposed by Pablo Fernandez (2008)
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Historical Equity Premium
Disadvantages:
Large volatility;
Survival bias;
Structural breaks on the long history of data;
Historical differential return of the stock market
over treasuries (Fernandez, 2008).
Historical Equity Premium for the US
according to different authors
Source: Fernandez (2008);
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Author(s) Reference/average Period for HEP HEP (%)
Siegel (2002) T-Bonds, geo. 1926-2001 4.9 %
Constantinides (2002) T-Bills, arith. 1926-2000 9.3%
Constantinides (2002) T-Bills, arith. 1872-2000 6.9%
Constantinides (2002) T-Bills, arith. 1951-2000 8.7%
Ibbotson and Chen (2003) T-Bonds, geo. 1926-2000 3.97%
Siegel (2005a) T-Bonds, geo. 1926-2004 4.53%
Ibbotson Associates (2006) T-Bonds arith. capital aprec. only 1926-2005 7.1%
Goetzmann and Ibbotson (2006) T-Bonds, geo. 1792-1925 2.83%
Goetzmann and Ibbotson (2006) T-Bonds, geo. 1926-2004 4.99%
Welch and Goyal (2008) 1872-2004 4.77%
Welch and Goyal (2008) 1927-2004 6.35%
Dimson et al.(2007) T-Bonds, geo. US 1900-2005 4.52%
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Expected Equity Premium
Disadvantages:
Wide interval of expectations got in surveys;
The results of surveys depends on the
professionals knowledge about the analyzed
capital market ;
Expected differential return of the stock market
over treasuries (Fernandez, 2008).
Estimates of the Expected Equity Risk
Premium resulted from surveys
Source: Fernandez (2008);
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Author(s) Conclusion about EEP Note
Pensions and Investments (1998) 3% Institutional investors
Graham and Harvey (2001) 4.65% CFOs
Welch (2000) 7% arithmetically, 5.2% geometrically Finance professors
Welch (2001) 5.5% arithmetically,
4.7% geometrically
Finance professors
Welch (2007) 5.75% arithmetically,
5% geometrically
Finance professors
O'Neill, Wilson and Masih (2002) 3.9% Global clients Goldman
Graham and Harvey (2007) 2.93% CFOs
Graham and Harvey (2008) 3,8% CFOs
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Required Equity Premium
Disadvantages:
Diversity of the models and their assumptions;
Existing models have difficulties in explaining the
equity premium and in justifying the difference in
rates of return across assets.
Incremental return of the market portfolio over the
risk free rate required by an investors in order to
hold the market portfolio (Fernandez, 2008).
Estimates of the Expected Equity Risk Premium
according to different authors
Source: Fernandez (2008);
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Author(s) Conclusion about EEP
Booth (1999) EEP = HEP - 2%
Pastor and Stambaugh (2001) 4 % - 6%
McGrattan and Prescott (2001) near zero
Arnott and Ryan (2001) near zero
Arnott and Bernstein (2002) near zero
Siegel (2002, 2005b) 2% - 3%
Ibbotson (2002) < 4%
Campbel (2002) 1.5% - 2%
Mayfield (2004) EEP = HEP - 2.4%= 5.9% + T-Bill
Bostock (2004) 0.6 1.8%
Welch and Goyal (2008) EEP = HEP
Dimson, Marsh and Stauton (2007) 3 - 3.5%
Grabowski (2006) 3.5 6%
Maheu and McCurdy (2008) 4.02% and 5.1%.
Ibbotson Associates (2006) EEP = HEP = 7.1%
Welch (2007) EEP = 7.9%
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Implied Equity Premium
Disadvantages:
Oversimplify the reality;
Can not be estimated in case of capital markets
with low liquidity, high volatility of stock returns.
The required equity premium that arise from a
pricing model and from assuming that the market
price is correct (Fernandez , 2008).
Implied Equity Premium and Required Equity Premium
according to different authors
DDM= dividend discount model. RIM = residual income model Source: Fernandez (2008);
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Author(s) Method Period IEP = REP (%)
Jagannathan et al. (2000) DDM 1926-1999 3.04%
Glassman and Hasset (2000) 3%
O'Hanlon and Steele (2000) accounting 1968-1995 4%to 6%
Harris and Marston (2001) DDM 1982-1998 7.14%
Claus and Thomas (2001) RIM 1985-1998 3%
Fama and French (2002) DDM 1951-2000 2.55%
Fama and French (2002) DDM 1872-1950 4.17%
Goedhart, Koller and Wessels (2002) DDM 1990-2000 3.5% to 4%
Ritter (2002) DDM 2001 0.7%
Ritter and Warr (2002) RIM 1979-1997 +12% to -4%
Easton et al. (2002) RIM 1981-1998 5.3%
Harris et al. (2003) DDM 1983-1998 7.3% to 9.7%
Vivian (2005) DDM & RIM 1951-2002 UK 4.6%
Ibbotson Associates (2006) REP=EEP=HEP 1926-2005 7.1%
Donaldson, Kamstra and Kramer (2007) DDM 1952-2004 3.5%
Damodaran (2008) DDM 1928-2008 4.54%
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Equity premium puzzle
ORIGINS:
Different semantics and elusiveness of
equity risk premium;
Contrary views of academics and
practitioners about:
Level of ERP to consider in assets valuation;
Models that should be used to estimate ERP;
Difficulty to read the investors mind;
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Main arguments
for the equity premium puzzle
The multidimensionality of equity premium;
The difficulty to gauge the investors perception of risk by
models;
The complexity of the theoretical models increase the gap
between theory and practice;
The sample mean of historic equity premium is a bad
estimator of the expected equity risk premium and is one,
if not the only one of the driving forces behind most
investors behavior.
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Main arguments
for the equity premium puzzle (cont)
Microtheory vs. Macrotheory perspective about ERP;
Investors are rational - classical assumption of
theoretical models that estimates ERP;
Although the behavioral models are pointing out the
impact of myopic loss aversion and investors focus on
short term returns, they are not based on a solid
ground about how investors actually behave.
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Practitioners rule of thumb in
estimating EPR - CAPM
75% of CFOs interviewed in a survey use
CAPM or version of CAPM to estimate EPR
(Graham&Harvey, 2001,2008)
Reasons:
simple formula;
clear cut link between risk and return;
availability of data:
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Challenges in applying CAPM for
international valuation
Questions to answer:
Which is the reference for the risk free rate?
What measure of risk should we choose to
quantify EPR?
What market portfolio should we consider to
estimate beta?
Is a multi-factor model a better tool then CAPM?
What other risk factor should we consider?
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Risk free rate
Domestic versus global;
Currency risk;
Differential Inflationary Expectations;
Expectations and the Term Structure of
Interest Rates;
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Implied sovereign spread (I)
Source: Pratt &Grabowski (2008, pp.317), calculations made by Duff&Phelps on data as of December 31,2006.
S&P
Rating
Rating
Score
CCR
Rating
Guideline
Yield
Spread
S&P
Rating
Rating
Score
CCR
Rating
Guideline
Yield
Spread
CC 22 0.0 6.23% BBB- 12 49.8 1.21%
CCC- 21 9.2 5.29% BBB 11 54.3 1.02%
CCC 20 13.7 4.49% BBB+ 10 58.8 0.87%
CCC+ 19 18.2 3.81% A- 9 63.3 0.74%
B- 18 22.7 3.23% A 8 67.8 0.63%
B 17 27.3 2.74% A+ 7 72.4 0.53%
B+ 16 31.8 2.33% AA- 6 76.9 0.45%
BB- 15 36.3 1.98% AA 5 81.4 0.38%
BB 14 40.8 1.68% AA+ 4 85.9 0.32%
BB+ 13 45.3 1.42% AAA 2 92.6 0.00%
Implied sovereign spread (II)
Source: Damodaran, A. - http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html,
Last updated: January 2009
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Moodys
Rating
Adj. Default
Spread
Country Risk
Premium
Moodys
Rating
Adj. Default
Spread
Country Risk
Premium
Caa1 12.00% 18.00% Baa1 2.00% 3.00%
B3 9.00% 13.50% A3 1.75% 2.63%
B2 7.50% 11.25% A2 1.60% 2.40%
B1 6.50% 9.75% A1 1.40% 2.10%
Ba3 5.25% 7.88% Aa3 1.20% 1.80%
Ba2 4.00% 6.00% Aa2 1.00% 1.50%
Ba1 3.00% 4.50% Aa1 0.70% 1.05%
Baa3 2.60% 3.90% Aaa 0.00% 0.00%
Baa2 2.25% 3.38%
Country risk premium (CRP)
Can be represented by the spread between the yield of
T-bonds issued by the state with AAA rating and the
yield of T-bonds issued by the state we consider in
valuation.
In order to value the investments in one companys
shares, the country risk premium should be adjusted in
order to quantify the higher volatility of investments
returns on capital market compare to the volatility of
investments returns in T-bonds;
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Country risk premium
- ways of estimation -
1) Country risk premium =
2) Country risk premium =
3) Country risk premium is
integrated in market risk
premium
eurobonds
ketIndex CountryMar
eurobonds spread
o
o

eurobonds spread
( ) ( )
US
f M
P S
ketIndex CountryMar
US
f M
R R R R =
500 &
o
o
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Measures of risk (I)
Beta a measure of systematic risk;
defined as the sensitivity of an assets returns
to changes in the markets returns (domestic
or/and global);
Standard deviation of an assets returns - a
measure of the total risk of the asset;
Total beta a measure of the asset's total
risk relative to market risk;
Beta vs. relative volatility
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Measures of risk (II)
Total beta derived calculation:
2 2 2 2
c
o o | o + =
M i i
Systematic Risk Companys Specific Risk
) 1 (
2
,
2 2 2
,
2 2 2 2 2
M i i i M i i M i i
o o o o | o o
c
= = =
) 1 (
2 2 2
R
i
=o o
c
) 1 (
2 2 2 2 2 2 2 2
R
i M i M i i
+ = + = o o | o o | o
c
2 2 2
2
2
2
M M
i
i
T
R
o | o
|
o = =
M
i
T
o
o
| =
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Measures of risk (III)
Semideviation of assets returns below the
mean or other benchmark return a
measure of the asset's total downsize risk;
Downsize beta - a measure of the asset's
downsize systematic risk;
Regular beta understates risk of low-beta
stocks and overstates risk of high-beta
stocks.
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Compensation for risk - EPR
What should we consider?
short term vs. long term investors perspective of
risk;
market characteristics :
Size
Liquidity
Skewness
Integration in world market
idiosyncratic (firm specific) risk
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Skewness of assets returns
distribution impact on ERP
Standard deviation and beta as a measure
of risk are not relevant when the
underlying distributions of returns is not
symmetric;
Semideviation and downsize beta capture
the returns distribution asymmetry;
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Emerging market integration in the
world market
In applying CAPM to estimate beta of an
investment in an emerging market what
market portfolio should we consider?
Local market portfolio;
or
Global market portfolio;
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What beta do you choose for
SNP (Petrom)? (I)
*Beta SNP is estimated for weekly total returns (EUR) and 5 years period (Apr 2009 Apr 2004).
Market
index
BETC BET ROTX MXWD MXEF MXEE MXEU S&P500
Beta 1.078 1.012 0.966 0.974 0.824 0.734 0.970 0.694
Alfa 0.0007 0.0003 0.0002 0.002 0.0004 0.0007 0.002 0.002
R
2
0.639 0.631 0.628 0.161 0.2 0.204 0.208 0.092
SE Alfa 0.002 0.002 0.002 0.003 0.003 0.003 0.003 0.003
SE Beta 0.051 0.048 0.046 0.14 0.103 0.091 0.119 0.137
Total
Beta
1.348 1.274 1.219 2.427 1.842 1.625 2.126 2.288
What beta do you choose for
SNP (Petrom)? (II)
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Market
index
BETC BET ROTX MXWD MXEF MXEE MXEU S&P500
DBeta 1.135 1.322 1.015 1.504 1.234 1.111 1.112 1.331
R
2
0.672 0.115 0.623 0.217 0.267 0.255 0.255 0.267
SE Beta 0.041 0.127 0.041 0.117 0.089 0.081 0.081 0.096
Relative
Semi-
deviation
2.355 2.024 1.314 2.396 1.877 1.709 1.710 1.710
*DBeta SNP is estimated for weekly total returns (EUR) and 5 years period (Apr 2009 Apr 2004).
The benchmark return is the arithmetic average weekly return.
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How do we measure local capital
market integration?
can be used to measure how integrated
the domestic market is in the global market;
( )
t t
t
WM LM t t LMt
Rf R Rf R c | o + + =
2 2
) (
LMGM
R =
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Local Capital Market integration (I)
The figures are estimated for weekly total returns (EUR), 3 years period (Apr 2006 Apr 2009)
and considering MXWD index.
Index Beta t-stat R
2
Index Beta t-stat R
2
BETC 0.971 8.323 0.314 RTSI 1.149 8.459 0.321
BG40 0.708 5.735 0.204 BUX 1.231 12.38 0.499
SVSM 0.611 8.493 0.319 CRO 0.770 8.211 0.304
VILSE 0.545 7.416 0.263 WIG 1.069 11.61 0.467
XU100 1.555 13.54 0.543 UKX 1.175 28.11 0.836
TALSE 0.480 5.812 0.179 CAC 1.109 27.12 0.826
RIGSE 0.360 4.992 0.139 DAX 1.154 26.00 0.814
PFTS 0.644 4.413 0.114 SPX 0.984 31.99 0.869
Local Capital Market integration (II)
The figures are estimated for weekly total returns (EUR), 3 years period (Apr 2003 Apr 2006)
and considering MXWD index.
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Index Beta t-stat R
2
Index Beta t-stat R
2
BETC 0.177 1.053 0.007 RTSI 0.939 5.125 0.147
BG40 - - - BUX 0.483 3.199 0.062
SVSM 0.034 0.490 0.001 CRO 0.017 0.121 0.000
VILSE 0.237 1.845 0.021 WIG 0.714 5.683 0.173
XU100 0.787 3.444 0.072 UKX 0.778 17.51 0.665
TALSE 0.311 2.999 0.055 CAC 0.849 18.80 0.696
RIGSE 0.319 2.734 0.046 DAX 1.07 17.35 0.661
PFTS 0.399 1.834 0.021 SPX 1.06 37.37 0.90
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How does beta reflect the impact of
market integration?
LM
iLM i
LM
iLM LM i
i
o
o
o
o o
|

=

=
2
WM
LMWM LM
WM
LMWM WM LM
LM
o
o
o
o o
|

=

=
2
LMWM
WM LM
LM

o |
o

=
WM
LMWM iLM i
LM i
o
o
| |

=
Market Risk Premium
Market risk premium represent extra
percentage points over the risk free rate
(Rf) that investors get when they invest in
market portfolio;
Market risk premium = RM - Rf
Domestic or global?
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BETC weekly returns statistics
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0
20
40
60
80
100
120
140
-0.2 -0.1 0.0 0.1
Series: BETC_WEEKLY_RETURNS_EU
Sample 1 474
Observations 474
Mean 0.002120
Median 0.002498
Maximum 0.164857
Minimum -0.252715
Std. Dev. 0.043092
Skewness -0.733249
Kurtosis 6.998025
Jarque-Bera 358.1626
Probability 0.000000
BETC 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
YR
M
-16.28% -16.51% 65,38% 7,38% 77,41% 42,19% 33,52% 30,84% -119,55% -8,62%
Y
29.23% 32.61% 29,47% 15,75% 21,52% 30,40% 20,87% 28,10% 29,93% 30,98%
YR
M
= yearly BETC average return; Y = yearly standard deviation of BETC returns. The figures are estimated by annualizing weekly average return
(measured in EUR) and standard deviation.
M
R
o
M
R
o
EPR estimation for emerging
markets example of models
recommended in finance literature
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Erb, Harvey and Viskanta model
(1996)
The case of emerging economies without capital
market or with one that has a short history
or/and low liquidity:
Risk ratings are available from Institutional Investors Country Credit
Risk, Euromoneys Country Risk Ratings, International Country Risk
Guide.
Cost of capital estimates for 136 countries are offered by the
program International Cost of Capital and Risk Calculator
(see http://www.duke.edu/~charvey/applets/iccrc.html).
( )
1 , , 1 0 ,
ln
+
+ + =
t i t i t i
CCR R c
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Lessard model (1996)
For segmented markets:
( )
LM i US f US M C US f i
R R SS R K | | + + =
, , ,
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Godfrey-Espinosa model (1996)
For segmented markets:
The coefficient 60% is meant to avoid double counting of risk and
represent the average across emerging economies of the risk
reflected by the stock market and not reflected by the bond market.
( )
WM
LM
f C LM E
R SS Rf K
o
o
+ + = % 60 R
WM ,
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Goldman Sachs model (1999)
For segmented markets:
- the correlation coefficient between local capital
market returns and T-bonds yields.
( ) ( )
WM
LM
LMBM f C LM E
R SS Rf K
o
o
+ + = 1 R
WM ,
LMBM

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Estrada model (2002) DCAPM
For stock markets with skewed returns distribution
and partially-integrated emerging markets:
- The model that counts only for downsize systematic risk:
- The model that counts for downsize total risk
( )
US f US M
D
i US f i
R R R K
, , ,
+ = |
( )
US M
i
US f US M US f i
SD
SD
R R R K
,
, , ,
+ =
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Damodaran model (1999)
For integrated markets:
Version 1
Version 2
( )
(
(

+ =
US E
LM E
US f US M i US f i
R R R K
,
,
, , ,
o
o
|
( )
LM B
LM E
C i US f US M i US f i
SS R R R K
,
,
, , ,
o
o
| + + =
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Butler Pinkerton Model (2007)
For integrated markets, and considering
company specific risk and size risk:
For private companies the estimation of CSPR for guideline companies
is followed by an analysis of private company specific risk factors.
( )
US f US M i US f i
R R T R TCOE
, , ,
+ = |
( )
i i US f US M i US f i
CSRP SP R R R TCOE + + + =
, , ,
|
( ) ( )
i US f US M i i i
SP R R T CSRP =
, ,
| |
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Cost of equity estimation -
aplication
Model Estimations K
SNP
Lessard model (1996)
K
SNP
= 3%+2.6%+6%x1.076x0.928 11.59%
Godfrey-Espinosa model
(1996)
K
SNP
= 3%+2.6%+6%x60%x(5.12%/2.78%) 12.33%
Goldman Sachs model
(1999)
K
SNP
= 3%+2.6%+6%x(1-0)x(5.12%/2.78%) 16.65%
Estrada model (2002) K
SNP
= 3% + 1.331x6%
K
SNP
= 3% + 1.710x6%
10.99%
13.26%
Damodaran model (1999) K
SNP
= 3% + 1.078x[6%x(5.12%/2.78%)]
K
SNP
= 3% + 1.078x6% + 1x2.6%x1.5
14.91%
13.64%
Butler Pinkerton Model
(2007)
K
SNP
= 3% + 2.28x6% 16.68%
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Which model would you chose
to estimate the discount rate
for an investment in an emerging market?
Erb, Harvey and Viskanta model (1996)
Lessard model (1996)
Godfrey-Espinosa model (1996)
Goldman Sachs model (1999)
Estrada model (2002) DCAPM
Damodaran model (1999)
Butler Pinkerton Model (2007)
None of them.
Ideas from some of them.
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Challenges of ERP estimation for
emerging markets
Frequent re-estimations are necessary;
The prospective EPR should include information
about probable changes in market characteristics
(e.g. degree of integration in global market);
Problems of transparency and illiquidity;
Short history of transactions.
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In ERP estimation we need a firm place to
stand on and maybe we will move the
Earth!
Thank you for joining us.
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Glossary of Abbreviations used in these slides (I)
2009 NACVA and IBAs Annual Consultants Conference
Valuation and Financial Forensics Educate, Communicate, Preserve
52
Abbreviation Meaning
R
f
Risk free rate (T-bond yield, 10 years maturity);
SS
c
Sovereign spread for country C;
CCR
i,t
Country Credit Risk for country i at the moment t;
R
M
(R
WM
) Market Return (local market return-R
LM
or world market return-R
WM
)
R
i,t
Market Return of country i at the moment t;
K
i
Cost of equity for the investment in asset i;
K
E,LM
Cost of equity for the investment in local capital market;
TCOE
i
Total cost of equity for the investment in asset i;
Standard deviation of returns for risky asset i;
Standard deviation of returns for local capital market portfolio;
Standard deviation of returns for world capital market portfolio;
Standard deviation of yields for T-bonds issued by country i;
SP
i
Size premium for the investment in asset i;
CSRP
i
Company specific risk premium for the investment in asset i;
i
o
LM
o
WM
o
LM B,
o
) (
,LM E
o
Glossary of Abbreviations used in these slides (II)
2009 NACVA and IBAs Annual Consultants Conference
Valuation and Financial Forensics Educate, Communicate, Preserve
53
Abbreviation Meaning
Correlation between the risky asset i and local market portfolio
returns;
Correlation between the local and world market portfolios returns;
Correlation between the local stock and T-bond markets returns;
Beta of the investment in asset i;
Beta of the investment in local market portfolio with respect to the
world market portfolio;
Downsize beta of the investment in asset i;
Total beta of the investment in asset i;
The company i exposure to country risk;
Relative semideviation of asset i returns below its mean with respect
to the semideviation of market portfolio returns below its mean.
R
2
Regression coefficient of determination
SE Alfa/Beta Standard error of Alfa/Beta coefficients estimates;
iLM

LMWM

LMBM

i
|
LM
|
D
i
|
i

i
T|
US M
i
SD
SD
,
Selected Bibliography:
Butler, P.J.; K.A. Pinkerton (2008), The Butler Pinkerton Model: Empirical Support for
Company-Specific Risk, The Value Examiner, May/June, 32-39
Damodaran, A. (2008), Equity Risk Premiums (ERP): Determinants, Estimation and
Implications, working paper, SSRN n. 1274967
Estrada,J. (2002), Systematic risk in emerging markets: the D-CAPM, Emerging Markets
Review, 365-379
Estrada,J. (2007), Discount Rates in Emerging Markets: Four Models and An
Application, Journal of Applied Corporate Finance, volume 19, Number 2, 72-77
Fernandez, P. (2008), "The Equity Premium Puzzle: high required equity Premium,
undervaluation and self fulfilling prophecy IESE Business School Working paper, SSRN
n. 1274816.
Graham, J.R., C.R. Harvey (2001), The theory and practice of corporate finance:
evidence from the field, Journal of Financial Economics, Vol. 60 No 2/3, pp. 187-243.
Graham, J.R., C.R. Harvey (2007), "The Equity Risk Premium in January 2007: Evidence
from the Global CFO Outlook Survey, Icfai Journal of Financial Risk Management, Vol.
IV, No. 2, pp. 46-61.
Harvey, C.R., (2005), 12 ways to calculate the international cost of capital, working
paper, Duke University
Pratt,S., R.,Grabowski, (2008), Cost of Capital: Applications and Examples, Third
Edition, John Wiley&Sons,Inc.
2009 NACVA and IBAs Annual Consultants Conference
Valuation and Financial Forensics Educate, Communicate, Preserve
54