Country Risk and the Global CAPM -

Evidence about Beta from the MSCI ACWI

Term Paper∗

University College London

January 11, 2018

Abstract

It is widely known, that there exists no general definition of country risk, that this is probably because
country risk is a multi-dimensional and complex concept and that the effects of the same country risks can be
both benficial and harmful dependent on the industry or firm. Nonetheless, adding a country risk premium
to the CAPM is conceived as a plausible measure of risk. This essay argues against this view and especially
against an argument against applying an unadjusted CAPM to emerging market countries, namely that
the beta of emerging countries is generally lower that the beta of developed countries. After arguing for not
adjusting the CAPM when it comes to valuation in emerging markets, this will be achieved by calculating
current emerging and developed country betas against the MSCI All Country World Index as well as their
rolling betas over time. It is found that the emerging markets’ average beta is not in generally higher both
currently and throughout time. Overall, the essay may contributes to a more transparent way of doing global
business valuations by being clear about the arbitrariness of the differet risk concepts used when trying to
adjust the CAPM.

Contents

I Introduction 2

II Should there be a Country Risk Premium? 2

III Estimating Betas for a Global CAPM 3

i Benchmark Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
ii Calculating Current Betas . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
iii Calculating Betas over Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

IV Concluding Remarks 9

∗ Thispaper was written for the course SEESGS50: Cor-

porate Finance and investment in Emerging Markets, held † StudentNumber: 17066036, M.A. Comparative Busi-
by Dr. Eugene Nivorozhkin. ness Economics.

1
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger
I. Introduction
he capital asset pricing model (CAPM)
T
is still the workhorse model when it
comes to determining the cost of eq-
uity. Although there are alternatives such as
multi-factor models or arbitrage pricing the-
ory, none of those has replaced the CAPM
and its dominant role in asset pricing yet
([Brealy et al., 2011]). Its standard version sim-
ply puts forth the linear relation between risk
and return as
r i = r f + β i (r m − r f ), (1)
where ri , rm , r f and β i denote the expected risk
premium on equity, the expected risk premium
on the benchmark (the market), the risk free
rate and the risk factor β respectively. The
CAPM’s risk factor, β, is therefore a measure of
how sensitive the equity’s excess returns, rie =
ri − r f , is to market excess return movements,
e
rm = rm − r f . With this, to estimate beta, a
simple OLS regression can be applied to
e e
ri,t = αi + β i rm,t + ε i,t (2)
with t being a time subscript, αi being the re-
gression constant and ε i,t being the error term.
The risk factor can therefore be interpreted as
the average rise or fall of equity i’s excess re-
turns, when the market rises or falls an extra
1%.
The CAPM’s simplicity made it not only
the workhorse model, but also an object of
constant criticism. Assuming that the reader
is somewhat familiar with the myriad of rea-
sonable critiques, this essay focuses on one in
particular, namely the common view that the
CAPM has to be adjusted by a country risk pre-
mium (CRP) when valuing projects or compa-
nies in emerging markets ([Damodaran, 2003],
2
[Estrada, 2007]). For this, the discussions about
whether or not to extend the CAPM and there-
fore the discount rate with country risk will
shortly be summarized. Following from that,
the view of applying an unadjusted CAPM to
emerging markets can be seen as consistent,
especially when assuming that the marginal in-
vestor is globally diversified. Thereafter, it will
be tried to explore whether or not the beta of
emerging market countries is generally lower
then the one of develped countries, a hypoth-
esis and common critique of applying an un-
adjusted CAPM to emerging markets, as pro-
posed e.g. by [Baker and Filbeck, 2015]. With
the MSCI All Country World Index (ACWI)
as a proxy for the market portfolio, the betas
of all developed and emerging MSCI country
indexes which are part of the ACWI are esti-
mated both currently and over time in order to
explore the betas’ average development. The
results, namely that the emerging markets’ av-
erage beta is not generally smaller, together
with its explanations and implications are dis-
cussed. A further hypothesis, that the vari-
ability of the emerging markets’ average beta
shrinks over time is put forth and might be
subject to further research.
II. Should there be a Country Risk
Premium?
Following from Markowitz’s portfolio theory,
a rational investor holding an efficient, well-
diversified portfolio is only subject to non-
diversifiable or market risk ([Markowitz, 1952].
Especially given that investors are only inter-
ested in a portfolio’s expected return and its
standard deviation, given borrowing and lend-
ing possibilities at r f and given an efficient,
competitive market, every investor would hold
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger
a combination of the market portfolio and a
risk-free loan. Within this framework, beta,
as a well-defined risk concept, measures the
contribution of an individual security to the
risk of a well-diversified portfolio. Diversi-
fiable risk does not affect the discount rate.
Someone proposing to adjust the CAPM with
country risk therefore needs to ask at least
two initial questions: First, whether there is
any reasonable and applicable definition of
country risk and second, whether this notion
of country risk is diversifiable. Regarding
the first, most authors implicitly or explic-
itly refer to risk factors specific to the coun-
try at interest such as political-, government
policy-, social-, macro- and microeconomic-
or natural risks [Bouchet et al., 2003]. In a
broad sense with the focus on political risk,
[Haendel et al., 1975] defined country risk as
the “probability of occurrence of political
events that will change the prospects for prof-
itability of a given investment”, defining it as
a performance variance risk concept. In this
sense e.g. a policy change could be harmful
for one industry or firm while being beneficial
for another. Other authors in turn define coun-
try risk as negative outcomes, i.e. as events
which, if they occur, negatively effect a firm’s
operations or investments [Roy and Roy, 1994].
Whether defined as performance variance or
negative outcomes, three caveats stand out:
First, there exists no general definition of coun-
try risk, second, this is probably because coun-
try risk is a multi-dimensional and complex
concept and third, the effects of country risks
can be differ across industries and firms (see
also [Bouchet et al., 2003]). Especially due to
the last point a general definition is hard to
imagine. But even if there were one, how could
we conclude that it would be non-diversifiable?
Non-diversifiability in portfolio theory simply
states that if holding a well-diversified (ran-
dom) portfolio, the variance will be the same
as the one of the market. This holds true even
if stock returns are correlated, as the market
is simply a weighted average of these returns.
The argument therefore that country risk can-
not be diversified due to correlation seems to
refer to the concept of systemic risk rather than
to systematic, i.e. non-diversifiable risk as used
in asset pricing. With regard to valuation, I
will therefore argue that country risk belongs
to the non-academic realm of calculating the ex-
pected cash flows. There, no defined concepts
are washed out, the assignment of probabili-
ties requires both thorough justification and
takes into the relevant factors for the individ-
ual company or operation and is not depen-
dent on a general definition of a CRP. Over-
all, adding a general country risk premium
to the CAPM without a general definition of
country risk thus makes the undertaking ar-
bitrary [Kruschwitz et al., 2012]. Adding an
an ill-defined CRP to the CAPM would trans-
late to an ill-defined discount rate, ignoring
the well-defined concept of the beta. The sub-
sequent analysis therefore starts with two as-
sumptions: First, that the CAPM does not have
to be adjusted by a CRP and second, that the
marginal investor is globally diversified.
III. Estimating Betas for a Global
CAPM
i. Benchmark Data
The latter assumption makes this analysis a
theoretical one. Following from [Lintner, 1965],
the market portfolio is an undetermined, gen-
eral market factor, which might, however, be
approximated by a stock index [Bimberg, 2009].
3
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger
The choice of the benchmark portfolio has a
large effect on the estimates of the beta and the
subsequent analysis should therefore serve as
one possible case, which can be easily modified
by using or constructing other benchmark in-
dexes with relevant weights of other marginal
investors [Brown and Brown, 1987]. Here, the
MSCI ACWI is used as a proxy for the mar-
ket portfolio. The index comprises 47 coun-
tries of which 23 are considered developed and
24 considered emerging markets according to
MSCI’s own classification [MSCI, 2017]. Each
Index includes about 85% of the free float ad-
justed market capitalization in each market
1. As the index is constructed using market
weights, the country shares differ widely with
the United States (US) representing 52.67 %
of the index and 632 out of 2490 constituent
companies, therefore being by far the largest
component[MSCI, 2017]. Although the con-
struction of the ACWI is not known in de-
tail, evidence suggests that the ACWI is sim-
ply a market capitalization weighted sum of
its comprising indexes, as reconstructed in ta-
ble 1 on page 5. The sum of the countries’
reported market shares and number of con-
stituents is identical to the numbers reported
for the MSCI ACWI2 . Emerging markets make
up only 11.53% in terms of the total capital-
ization, resulting from 33.61% of the contained
companies. An average developed market com-
pany in the ACWI has therefore a market capi-
talization 4 times higher than the market capi-
talization of an average emerging market com-
pany (24.114 vs. 6.208 billion). The US con-
1 MSCIdefines free float as total shares outstanding ex-
cluding shares held by strategic investors such as govern-
ments, corporations, controlling shareholders, and manage-
ment, and shares subject to foreign ownership restrictions
[MSCI, 2000].
2 Ignoring the tiny difference of 53 million.
4
tributes to the index nearly 5 times as much as
emerging markets in total, an unbalance also
driven by the US focus of MSCI Inc. Note that
the results presented are as of November 2017
only, a complete reconstruction of the index
would require the weights of all (changing)
constituent indexes since the creation of the in-
dex. This not being necessary and lacking the
market share data over time, the MSCI ACWI
price index provided by Datastream is used
instead of constructing the index. In the next
section the returns, both monthly and weekly,
of all country indexes will be regressed against
the returns of the market in order to determine
the country betas. The country beta of coun-
try x can then be interpreted as the average
beta of the companies (in country x) against
the ACWI.
ii. Calculating Current Betas
First, simple and logarithmic (log) returns
are calculated for all country indexes and the
ACWI, both weekly and monthly, by taking the
first and last value of the period. I.e. simple
returns for period t are calculated as
l −p f
s
pi,t i
ri,t = f
(3)
pi,t
l and
for weekly and monthly periods, where pi,t
f
pi,t denote the last and first value of period t
respectively. Log returns can then be written
as
l
pi,t
l
ri,t og = log( f
). (4)
pi,t
For an initial application of regression 2 a time
span of two years for weekly returns and a
time span of five years for monthly returns is
used in order to have a reasonable amount of
data.
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger

Table 1: Contructing the ACWI: Developed and Emerging Markets Indexes with Market Share and Number of
Constituents. As of November 2017. Datasource: Thomson Reuters via Datastream. Own summary and
calculations.

5
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger
However, choosing the time span in practice
should also reveal how much weight is put
on recent or past events, which should be de-
termined by the valuation object. The price
development and the respective returns can
be regarded in figure 1 for the MSCI ACWI.
As expected, the return series are graphically
close to a random walk and are mean-reverting.
Regarding the return distributions, a first intu-
ition can be gained by looking at a histogram
of both weekly and monthly returns and com-
paring it no normally distributed data. As the
return distributions do not differ in any rel-
evant way when comparing log and simple
returns, only log returns are depicted. As can
been seen in figure 2, both weekly and monthly
log returns of the MSCI ACWI have more ob-
servations around the mean. Expected long
tails cannot be detected in figure 2. The graph-
ical analysis gives reason to look at the distri-
butions of all constiuent indexes in more de-
tail. Table 2 therefore summarizes relevant de-
scriptive statistics, including the skewness and
kurtosis and shows the results of the Jarque-
Bera normality test. The Jarque-Bera test tests
whether sample data have the skewness and
kurtosis matching a normal distribution. Go-
ing back to figure 2, the distirbution of the
MSCI ACWI’s returns resemble a double expo-
nential distribution for which we would expect
the skewness to be around 0 and the kurtosis
to be greater than 3. Table 2 reveals that this
is indeed true not only for the benchmark re-
turns but also for most other countries3 .
a significant level of 1% the null-hypothesis of
normally distributed returns is rejected for 17
out of 48 countries when considering weekly,
3 Note that the exceptional kurtosis for egypt’s weekly
returns is due a massive dip in November 2016. As the
MSCI Egypt only comprises 3 stocks this is not representa-
tive for the country.
6
and for 5 countries when considering monthly
returns. For the subsequent analysis, the fact
that the returns are not normally distributed
as described should be kept in mind.
Next, country betas are calculated for both
weekly and monthly log returns, for 2 years
and 5 years respectively, of which the results
can be seen in table 3. The betas are pre-
sented also market weighted in order to show
that the average weigthed beta equals 1. It
is striking that the variability among the de-
veloped countries’ betas is much lower then
those of the emerging countries’ betas, rang-
ing from 0.262 (Pakistan) to 1.952 (Greece) for
monthly returns, and from 0.461 (Russia) to
3.034 (Greece) for weekly returns. The aver-
age non-weighted beta of developed markets is
slightly higher compared to the average beta of
emerging markets. This might seem “strange”
or “unexpecte” at first, but remembering that
the beta simple measures return movements
in comparison to the benchmark it cannot be
held responsible to be an all-comprising risk
factor, as referred to in section II. If the Pak-
istan stock market tumbles due to some event
and the benchmark is not effected due to Pak-
istan’s relatively low market capitalization or
more systematic if there are factors benefit-
ting for the US market while threatening to
pakistani stocks, then Pakistan’s beta will be
lower. While [Baker and Filbeck, 2015] state
that “risky emerging markets report low be-
With tas”, data reveals that this is not generally true.
What is true, is that the variability of emerging
market betas is higher between the countries.
The average however resembles those of devel-
oped markets.
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger

Figure 1: Weekly and Monthly Log Returns and Prices. Datasource: Thomson Reuters via Datastream. Own depictions
and calculations.

Figure 2: A Graphical Impression: Histogramm with Normal Curve for Weekly and Monthly Log Returns for the
MSCI ACWI. Datasource: Thomson Reuters via Datastream. Own depictions and calculations.

7
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger

Table 2: Testing the Normality of Returns: Descriptive Statistics. Datasource: Thomson Reuters via Datastream. Own
summary and calculations.

8
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger
As a next step it will be analysed whether
the variability of the beta is not only the case
between countries, but also within countries,
i.e. it will be looked at how the average beta
of emerging markets evolved over time in com-
parison to developed markets.
iii. Calculating Betas over Time
Rolling regressions are applied to all the avail-
able index data. The regressions are the same
as before with the only difference that they are
used repeatedly while moving in time. Before
continuing the analysis, some caveats of false
interpretation are put forth. As the benchmark
index started earlier than many of the country
indexes, the averages do vary in the number of
countries incorporated. The latest country in-
dexes started in May 2005 however (Quatar and
the United Arab Emirated), setting the date
from which on all current constituent countries
contribute to the average. Furthermore, current
classifications are used, not be appropriate for
all the times analysed. The assumption is there-
fore, that this does not influence the outcomes
in any significant way.
The results are depicted in figure 3. Despite
the mentioned caveats, the analysis may under-
line at least two major points. First, it supports
the finding of the previous section, namely that
it cannot be concluded that emerging market
betas are generally lower than those of devel-
oped markets over time. This is more evident
when regarding the results for monthly return
data. The statement that market capitalization
lowers beta might therefore be questioned. Sec-
ond, an increased market capitalization over
time might result into a lower variance of the
average beta, as markets become more ma-
ture and uncertainty is eventually diminished.
While the first point is a strong one, the second
one should be considered as an educated hy-
pothesis. Further research would be necessary
to hold it.
IV. Concluding Remarks
If the marginal investor is globally diversified,
so it was argued here, he should apply a global
CAPM. This does not mean that it is assumed
that beta contains country risk. Beta as a sim-
ple “return comparing” instrument is not con-
structed to be an all-encompsasing risk mea-
sure. If country risk was present in the past,
then it might be to some extend reflected by
the returns and therefore beta. However, es-
pecially when it comes to valuation, adjusting
the cashflows with the best available probabili-
ties for country risk factor should be applied.
How this should be done is a separate question,
for which to provide an answer was not the
goal of this essay. Instead, after speaking in
favor for applying a global CAPM, the beta
of emerging and developed markets was scru-
tinized. Adding to the argumentative results
put forth against incorporating an ambiguous
CRP, quantitative results were found. Most of
all that it cannot be concluded that the average
emerging markets’ beta is lower, although the
betas between the individual emerging market
countries vary more. A result also underlined
when observing the evolution of the average
emerging markets’ beta over time in compari-
son to developed markets. Overall, the essay
might help to take a global CAPM a bit more
seriously by disregarding at least one main ar-
gument quantitatively, namely that the beta of
emerging markets is generally lower, and by ar-
guing against other commonly hold views such
as that correlation among emerging markets
adds to non-diversifiable risk. In the end,
9
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger

Table 3: Calculating Betas for all Countries using Weekly and Monthly Log Returns. Note that the sum equals not
exactly one due to rounding differences. Datasource: Thomson Reuters via Datastream. Own summary and
calculations.

10
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger

Figure 3: Rolling Regressions: Average Betas for Emerging and Developed Markets for Both Monthly and Weekly Log
Returns. Datasource: Thomson Reuters via Datastream. Own depictions and calculations.

11
 Country Risk and the Global CAPM • January 2018 • Florian Aichinger

the essay may contribute to a more transparent [Kruschwitz et al., 2012] Kruschwitz, L.; Loef-
way of doing global business valuations by fler A.; Mandl, G. (2012) DamodaranâĂŹs
being clear about the arbitrariness of differet Country Risk: A Serious Critique Business
concepts. Valuation Review Vol. 31

[Lintner, 1965] Lintner, J. (1965) The Valuation

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