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In method two, start with an international currency denominated bond of long duration, and estimate the stripped yield. Then subtract the sovereign-risk premium. If using cash flows denominated in local nominal currency, account for local inflation in the risk-free rate. The international currency bond already has the international currency inflation rate embedded in it, so just add the difference between the international inflation rate and the local rate. You can do this by adding the inflation difference
5 Some emerging markets' country debt is partially guaranteed by international institutions or backed by U.S. Treasury bonds. For these bonds, you need to estimate the yield on the non-guaranteed part of the bond, the "stripped" yield. Stripped yields are available from bond data suppliers.
year by year to develop a separate estimate of the cost of capital by year. You can also compound the inflation difference between the countries and add it as a single number to calculate a single cost of capital for all periods. The level of inflation difference dictates the choice of methods. If it is high, an annual estimate of the cost of capital is preferable.
Method three is the simplest and is available as an option in all countries. It starts with the 10-year U.S. government yield and adds an inflation differential between the U.S. and the local rate to develop a local nominal risk-free rate.
The key assumption in the calculation of the risk-free rate is that most investors, including investors in local markets, have access to an international risk-free rate. In countries such as India or China, however, local investors do not have access to a global risk-free rate. The most risk-free instrument available to them is the local government debt, which has sovereign risk embedded in the yield. This difference in access to a risk-free rate means that foreign investors will have a lower cost of capital than local investors, at least in the short run. As capital controls ease, this difference should disappear. Determining the timing of this is subjective and should be included as part of a scenario.
In the previous discussion, we laid out a rationale for excluding country risk. If you do wish to include a country-risk premium, start with the sovereign risk. The sovereign risk can be calculated by subtracting the 10-year U.S. government bond yield from a U.S. dollar-denominated local bond's stripped yield. If there is no U.S. dollar-denominated bond, subtract the inflation differential between the local country and the United States first to calculate the country sovereign-risk premium.
The next step is more controversial—subtracting the credit risk embedded in the yield. This is an attempt to estimate the cost of equity. Again, we do not believe that it is appropriate to include the risk of default and credit deterioration that make up the credit risk of a bond in the cost of equity calculation. The market-risk premium for equity already includes the possibility of losing your investment and so to include that risk again represents double counting.
So how do we eliminate the credit risk? There is no exact way to determine what part of the country-risk premium is associated with credit risk, so we approximate. Assume that since the bond-rating companies have standard criteria for rating bonds worldwide, the premium on bonds with a particular rating is similar across all bonds. The premium associated with a particular rating is readily available for U.S. corporate bonds from the bond rating agencies. The premium for a BB-rated bond can be estimated by taking the difference between the yield to maturity on 10-year BB-rated U.S. corporate bonds and the 10-year U.S. government bonds. This can be used as a proxy for the credit-risk premium included in the country's yield to maturity, whose debt is rated BB. Argentina's debt is rated BB and its country-risk
Exhibit 19.10 How to Calculate the Country Risk Premium—Argentine Example
Country risk Country sovereign Credit risk Inflation
premium risk premium premium differential
Argentina extrapolatedt 10-year yield ($ denominated)
U.S. 10-year treasury bond yield
Argentina sovereign risk premium
Credit risk (BB) premium
Country risk premium
premium is calculated in Exhibit 19.10 as an example. Note that this calculation is for the country-risk premium at a certain point in time. The country-risk premium varies significantly. The question becomes which country-risk premium to use, the current market estimate or a long-run estimate? If a long-run estimate is used, shouldn't the country-risk premium decline to zero, as the country's market becomes more stable and open? In general, we recommend starting with the current estimate and taking it down to zero at least by the end of the explicit forecast period.
The beta, a measure of a company's systematic risk, is often difficult to calculate accurately in emerging markets, where the equity market is illiquid and often dominated by a small number of stocks. Additionally, historical data do not go back far enough to have appropriately large sample sizes for reliable regressions. Beta estimation through regressions is therefore likely to be flawed.