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Risk Analysis and Project Evaluation
Campbell R. HarveyDuke University, NBER and
Investment Strategy Advisor, Man Group, plc
February 1, 2017
International Finance
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• Prerequisite to any evaluation of a project is a keen knowledge of both the local and global environments
• Project evaluation requires skills in finance, economics, accounting, political science, psychology, sociology, and history.
• Local knowledge, while necessary, is not sufficient. The local environment is impacted by the global environment.
The Setting
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Global Macro Issues• Shifting of risks from emerging to developed markets• Potential slowing of growth in emerging markets• Transition from partial integration to full• Ugly contests in FX; challenges to fiat currency• Trade wars (tariffs, non‐tariff barriers, border taxes, tax wars)• Commodities and the environment
The Setting
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The Setting
Wide variation in risk
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Do Benefits Outweigh the Costs?• Expected cash flows need to be discounted to present value• It is difficult to both forecast the cash flows and determine the appropriate discount rate
• Risk can be reflected in either the cash flows or the discount rate
Goal of Project Evaluation
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Do Benefits Outweigh the Costs?• Simple example. If project risk free, suppose cash flows are 100 per year, forever, and “risk free rate” is 5%. The value is:
.= 2,000
Numerator and Denominator
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Do Benefits Outweigh the Costs?• Suppose the project is risky. • Method 1 – Adjust the Cash Flows:
Numerator and Denominator
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.= 1,000
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Do Benefits Outweigh the Costs?• Suppose the project is risky. • Method 2 – Adjust the Discount Rate:
Numerator and Denominator
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.= 1,000
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Do Benefits Outweigh the Costs?• Our goal is to come to an understanding at both a country and project level of how to adjust for risk
• It does not matter if we adjust the numerator or the denominator
Goal of Project Evaluation
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What is risk?• There are many different views of risk.
Numerator and Denominator
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Key intuition• If risk can be diversified, then it should not be rewarded. If it is rewarded, then there is an arbitrage possibility.
• Simple model measures risk as the sensitivity to returns on a globally diversified wealth portfolio.
Model 1: CAPM
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What are the sources of risk?• Common (or systematic) risks. All projects are impacted to some degree by common risks. This impact is called the “beta” or “exposure”
• Idiosyncratic risk. These risk are specific to the project.
Model 1: CAPM
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World CAPM• Expected discount rate (in U.S. dollars) on investment that has average in a country
= riskfree + x world risk premium• Beta is measured relative to a “world” portfolio• Works fine for developed markets if we allow risk to change through time (Harvey 1991)
Model 1: CAPM
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World CAPM• Fails in most emerging markets• Strong assumptions needed• Perfect market integration• Mean‐variance analysis implied by utility assumptions
Model 1: CAPM
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• This model is widely used by consultants*• Addresses the problem that the CAPM gives a discount rate too low.• Solution: Add the sovereign yield spread which is the yield spread between a sovereign bond issued in US dollars against a similar maturity US Treasury bond
• Spread is a proxy for “country risk”
Model 2: Sovereign Spread
*J.O. Mariscal and R. M. Lee, The valuation of Mexican Stocks: An extension of the capitalasset pricing model to emerging markets, Goldman Sachs, June 18, 1993.
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Issues• Ad hoc (no theory) and untested empirically• Bolt‐on to a flawed CAPM• May give unreasonably low cost of equity capital• Any country risk premium reflected in a bond spread will not necessarily reflect the equity premium – because bonds are less risky than equities
Model 2: Sovereign Spread
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• Idea is to adjust the sovereign spread to make it more like an equity premium rather than a bond premium*
Model 2a: Adjusted Sovereign Spread
A. Damodaran, Estimating equity risk premiums, working paper, NYU, undated.Campbell R. Harvey 2017
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Damodaran
Country Sovereign Equity std. dev.equity = yield x ‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐premium spread Bond std. dev.
Model 2a: Adjusted Sovereign Spread
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Damodaran• Advantage: Recognizes that you just can’t use the bond yield spread as a plug number in the CAPM
• Disadvantage: Sovereign spread contains more than “country‐specific” risk
Model 2a: Adjusted Sovereign Spread
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Issues:“Since Damodaran’s country risk premium can be neither theoretically nor empirically supported, the rates of return on capital that are derived by such methods are highly arbitrary.”*
Model 2a: Adjusted Sovereign Spread
Campbell R. Harvey 2017*Kruschwitz, Loeffler and Mandl, 2010, Damodaran’s Country Risk Premium: A Serious Critique.
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Model 2a: Adjusted Sovereign Spread
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U.S. High Yield Spread(bp)
EMBI+ CompositeSpread (bp)
Sovereign spreads and measures of global risk
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• Note that US credit spreads are strongly correlated with sovereign spreads
• So sovereign spreads include more than country‐specific information
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• Empirical model derived from correlating current country credit rating to future equity returns*
• Impressive fit to data (for both developed and emerging markets)
Model 3: Erb, Harvey, Viskanta
*C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Journal of Portfolio Management, 1995.Campbell R. Harvey 2017
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Model 3: Erb, Harvey, Viskanta
Returns and Institutional Investor Country Credit Ratings from 1990
R2 = 0.2976
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0 20 40 60 80 100
Rating
Ave
rage
retu
rns
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• Just need a slope and an intercept
• Slope is negative ‐0.177 (lower rating means higher risk and higher discount rate)
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Formula:
Discount Rate = risk free + intercept ‐ slope x Log(IICCR)
• Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating
Model 3: Erb, Harvey, Viskanta
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Model adopted by Duff & Phelps
World’s leading commercial experts on valuation
Model 3: Erb, Harvey, Viskanta
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Model 3: Erb, Harvey, Viskanta
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Model 3: Erb, Harvey, Viskanta
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• Notice they implement with local currency returns
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Model 3: Erb, Harvey, Viskanta
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Assume we exactly know the US equity risk premium
• Each quarter the Duke‐CFO survey asks senior US executives for their view of the 10‐year equity risk premium
Model 3a: Adjusted Erb, Harvey, Viskanta
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1
2
3
4
5
Exce
ss re
turn
fore
cast
%
10-year forecasted S&P 500 (mean) annual returns over and above the 10-year Treasury bond yield
Figure 1a
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Assume we know the US equity risk premium
• Anchored model exactly delivers the known U.S. risk premium when we put the US country credit rating into the model
• Essentially, we are shifting the line to exactly match one data point that we know
Model 3a: Adjusted Erb, Harvey, Viskanta
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Model 3a: Adjusted Erb, Harvey, Viskanta
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[Anchored] C13 = B9+100*(0.898‐0.177*LN(B12)) ‐ ((B9+100*(0.898‐0.177*LN(B11)))‐(B10+B9))
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Operating Risks: Country Specific
• Sovereign Risk (Macroeconomic)– Exchange rate changes
– Currency convertibility and transferability
– Hyperinflation risk
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• 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
• Sovereign Risk (Force Majeure)– Political events
• Wars• Labor strikes• Terrorism• Changes in laws
– Natural catastrophes• Hurricanes/earthquakes/floods
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Operating Risks: Country Specific
• Pre‐completion– Resources available (quality/quantity)
– Technological risk (proven technology?)
– Timing risks (failure to meet milestones)
– Completion risk
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• Post‐completion– Market risks (prices of outputs)
– Supply/input risk (availability)
– Throughput risk (material put through plus efficacy of systems operations)
– Operating costs
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Method• Use adjusted EHV model to get a baseline cost of equity capital for a project of average risk within a country
• Adjust key project‐specific risk exposures if the project’s risks are different from the country average
Model 3a: Adjusted Erb, Harvey, Viskanta
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Model 3a: Adjusted Erb, Harvey, Viskanta
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Project Risk Mitigation (-10 to 10; where 10=risk completely eliminated, 0=average for country)
Weights Score
Impact on Country Premium
Sovereign0.40 0.00 0.00 Currency (direct, e.g. convertibility)0.10 0.00 0.00 Currency (indirect, e.g. political risk caused by crisis)0.15 0.00 0.00 Expropriation (direct, diversion, creeping)0.05 0.00 0.00 Commercial International partners0.05 0.00 0.00 Involvement of Multilateral Agencies0.05 0.00 0.00 Sensitivity of Project to wars, strikes, terrorism0.05 0.00 0.00 Sensitivity of Project to natural disasters
Operating0.05 0.00 0.00 Resource risk0.03 0.00 0.00 Technology risk
Financial0.05 0.00 0.00 Probability of Default0.03 0.00 0.00 Political Risk Insurance
1.00 Sum of weights (make sure = 1.00)
Project Cost of Capital 9.82
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• There is no textbook agreement on how to measure the cost of equity capital in international markets
• EHV model is the only model that “fits” the data• Nevertheless, best to look at a variety of estimates
Conclusions
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The Instructor
Campbell R. Harvey is the J. Paul Sticht Professor of International Business at the Fuqua School of Business, Duke University.He is also a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts. He served as 2016President of the American Finance Association.
Professor Harvey obtained his doctorate at the University of Chicago in business finance. His undergraduate studies ineconomics were conducted at the University of Toronto. He has served on the faculties of the Stockholm School of Economics, theHelsinki School of Economics, and the Graduate School of Business at the University of Chicago. He has also been a visiting scholar atthe Board of Governors of the Federal Reserve System. He was recently awarded an honorary doctorate from SvenskaHandelshögskolan in Helsinki.
Harvey is an internationally recognized expert in portfolio management and global risk management. His work on theimplications of changing risk and the dynamics of risk premiums for tactical asset allocation has been published in the top academic andpractitioner journals. He has published over 125 scholarly articles and books. His work is frequently presented in internationalconferences and is often featured in the business press.
In addition, Professor Harvey has wide‐ranging practical experience. He serves as Investment Strategy Advisor to the ManGroup, the world’s largest listed hedge fund group.
Harvey served as Editor of the Journal of Finance which is the leading scientific publication in the field of finance and thesecond highest rated journal in the economics profession between 2006‐2012.
Harvey has been awarded seven Graham and Dodd Awards/Scrolls for excellence in financial writing from the CFA Institute.Harvey is past winner of the Outstanding Faculty Award at the Fuqua School of Business, an annual award given by the students.
Campbell R. Harvey 2017