Musings on Markets Thu, 20 Feb 2020 03:09:00 GMT language
- Life Cycle: As companies go through the life cycle, their risk profiles changes with risk dampening as they mature. Countries go through their own version of the life cycle, with developed and more mature markets having more settled risk profiles than emerging economies which are still growing, changing and generally more risky. High growth economies tend to also have higher volatility in growth than low growth economies.
- Political Risk: A political structure that is unstable adds to economic risk, by making regulatory and tax law volatile, and adding unpredictable costs to businesses. While there are some investors and businesses that believe autocracies and dictatorships offer more stability than democracies, I would argue for nuance. I believe that autocracies do offer more temporal stability but they are also more exposed to more jarring, discontinuous change.
- Legal Risk: Businesses and investments are heavily dependent on legal systems that enforce contracts and ownership rights. Countries with dysfunctional legal systems will create more risk for investors than countries where the legal systems works well and in a timely fashion.
- Economic Structure: Some countries have more risk exposure simply because they are overly dependent on an industry or commodity for their prosperity, and an industry downturn or a commodity price drop can send their economies into a tailspin. Any businesses that operate in these countries are consequently exposed to this volatility.
a. Country Risk Scores: There are services that measure country risk with scores, trying to capture exposure to all of the risks listed above. The scores are subjective judgments and are not quite comparable across services, because each service scales risk differently. The World Bank provides an array of governance indicators (from corruption to political stability) for 214 countries (https://databank.worldbank.org/source/worldwide-governance-indicators#) , whereas Political Risk Services (PRS) measures a composite risk score for each country, with low (high) scores corresponding to high (low) country risk.
- Riskfree Rate in currency = Government bond rate – Default Spread for sovereign local-currency rating
- Riskfree Rate in Rupees on January 1, 2020 = Indian Government Rupee Bond rate on January 1, 2020 – Default spread based on Baa2 rating = 6.56% - 1.59% = 4.95%
- Riskfree Rate in Brazilian $R = Brazilian Government $R Bond rate on January 1, 2020 – Default spread based on Ba2 rating = 6.77% - 2.51% = 4.26%
Note that these estimates are only as good as the three data inputs that go into them. First, the government bond rates reported have to reflect a traded and liquid bond, clearly not an issue with the US treasury or German Euro bond, but a stretch for the Zambian kwacha bond. Second, the local currency rating is a good measure of the default risk, a challenge when ratings agencies are biased or late in adjusting. Third, the default spread, given the ratings class, is estimated without bias and reflects the market at the time of the assessment.
Local Currency Risk free rate = US T.Bond Rate + (Inflation rate in local currency - Inflation rate in US dollars)
In the full calculation, you incorporate the compounding effects of the differential inflation
- Currencies with no government bonds outstanding: There are more than 120 currencies, where there are no government bonds in the local currency; the country borrows from banks and the IMF, not from markets. Without a government bond rate, the approach described above becomes moot.
- Currencies where the government bond rate is not trustworthy: There are currencies where there is a government bond, with a rate, but an absence of liquidity and/or the presence of institutions being forced to buy the bond by the government that may make the rates untrustworthy. I don't mean to cast aspersions, but I seriously doubt that the Zambian Kwacha bond, whose rate I specified in the last section, has a deep or wide market.
- Pegged Currencies: There are some currencies that have been pegged to the US dollar, either for convenience (much of the Middle East) or stability (Ecuador). While analysts in these markets often use the US T.Bond rate as the risk free rate, there is a very real danger that what is pegged today may be unpegged in the future, especially when the fundamentals don't support the peg. Specifically, if the local inflation rate is much higher than the inflation rate in the US, it may be more prudent to use the synthetic risk free rate instead of the US T.Bond rate as the risk free rate.
- Casual Dollarization: In casual dollarization, you start by estimating your costs of equity and capital in US dollars, partly because you do not want to or cannot estimate risk free rates in a local currency. You then convert your expected future cash flows in the local currency and convert them to dollars using the current exchange rate. That represents a fatal step, since the inflation differentials that cause risk free rates to be different will also cause exchange rates to change over time. Purchasing power parity may be a crude approximation of reality, but it is a reality that will eventually hold, and ignoring can lead to valuation errors that are huge.
- Corporate hurdle rates: I have long argued against computing a corporate cost of capital and using it as a hurdle rate on investments and acquisitions, and that argument gets even stronger, when the investments or acquisitions are cross-border and in different currencies. If a European company takes its Euro cost of capital and uses it to value Hungarian, Polish or Russian companies, not correcting for either country risk or currency differentials, it will find a lot of “bargains”.
- Mismatched Currency Frames of Reference: We all have frames of reference that are built into our thinking, based upon where we live and the currencies we deal with. Having lived in the US for 40 years and dealt with more US companies than companies in any other market, I tend to think in US dollar terms, when I think of reasonable, high or low growth rates. While that is understandable, I have to remember that when conversing with an Indian analyst in Mumbai, whose day-to-day dealings in rupees, the growth rates that he or she provides me for a company will be in rupees. Consequently, it behooves both of us to be explicit about currencies (my expected growth rate for Infosys, in US dollars, is 4.5% or my cost of capital, in Indian rupees, is 10%) when making statements, even though it is cumbersome.
- Ratings and Sovereign CDS spreads, by country (January 2020)
- Country Equity Risk Premiums in January 2020
- Government Bond Rates and Riskfree Rates by Currency in January 2020
- Synthetic Riskfree Rates in 2020 (with inflation rates by currency)
Data Update Posts
- Data Update 1 for 2020: Setting the Table
- Data Update 2 for 2020: Retrospective on a Disruptive Decade
- Data Update 3 for 2020: The Price of Risk!
- Data Update 4 for 2020: Country and Currency Effects