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Emerging Financial Markets 9 : International Cost of Capital

Emerging Financial Markets 9 : International Cost of Capital. Prof. J.P. Mei. Many material here is adopted from Erb, Harvey, Viscanta’s presentation at Ibbotson Associates’ Cost of Capital Conference. International Cost of Capital Models Identical Cost of Capital (for all locations)

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Emerging Financial Markets 9 : International Cost of Capital

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  1. Emerging Financial Markets9: International Cost of Capital Prof. J.P. Mei Many material here is adopted from Erb, Harvey, Viscanta’s presentation at Ibbotson Associates’ Cost of Capital Conference

  2. International Cost of Capital Models • Identical Cost of Capital (for all locations) • World CAPM or Multifactor Model (Sharpe-Ross) • Segmented/Integrated (Bekaert-Harvey) • Credit Rating (Erb-Harvey-Viskanta) • Goldman-integrated sovereign yield spread model • Goldman-segmented • Goldman-EHV hybrid • CSFB volatility ratio model

  3. The International Cost of Capital • Identical Cost of Capital • Ignores the fact that shareholders require different expected returns for different risks • Destroys value • Avoid

  4. The 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

  5. The International Cost of Capital • Segmented/Integrated CAPM • Expected return a function of covariance with world and covariance with local index • Weights 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

  6. The International Cost of Capital • Credit Rating Model • Erb, Harvey and Viskanta (1995) • http://www.duke.edu/~charvey/applets/iccrc.html • Credit rating a good ex ante measure of risk • Impressive fit to data • Intuitive • Can be used in 136 countries, that is, in countries without equity markets • Fits developed and emerging markets

  7. The International Cost of Capital • Goldman-Integrated (EHV Hybrid) • Estimate market beta on the S&P 500 • Beta times historical US premium • Add sovereign yield spread • Goldman model only useful if you have sovereign yield spread • Use EHV model to fit ratings on yield spread

  8. The International Cost of Capital • CSFB • E[r]=SY+ß{E[r-RF] x A} x K • SY= Brady bond yield (or use fitted from EHV) • ß= beta of a stock against a local index • A= the coefficient of variation (CV) in the local market divided by the CV of the US market, where CV= standard deviation/mean • K is an adjustment factor to allow for correlation between risk free and risk premium (set=0.6)

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