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Doctorado en

Finanzas de Empresa
(ISSN: 1698-8183)

Documento de Trabajo
Universidad Complutense
0901 Universidad Autónoma

A MODIFIED CAPM VALUATION MODEL FOR LATIN


AMERICAN EMERGING MARKETS

Autores: Alfonso HAMARD y Prosper LAMOTHE

2009
A MODIFIED CAPM VALUATION MODEL FOR LATIN AMERICAN
EMERGING MARKETS

Alfonso Hamard*, Prosper Lamothe**

Abstract

This paper analyses the systematic risk factors associated to long-term


investments in Latin American Emerging Markets in order to estimate the
discount rate to be used by an investor localized in a developed market.

In order to do so, we review the main valuation approaches based on the


CAPM model, focusing in the foreign exchange risk. Due to the high
correlation between the emerging markets stock indices, and also to the
stochastic nature of the exchange risk, we proposed a modified version of the
CAPM that explicitly includes a foreign exchange risk premium in the discount
rate. The empirical comparison of the proposed model using 43 stocks
included in the stock markets indexes from Brazil, Chile and Mexico, we find
that the proposed model outperforms another well-known model by showing a
lower prediction error as measured by MAPE, RMSE and U-Theil scores.

Keywords: emerging market investments, foreign exchange risk, forecast


error measures, cost of equity, discount rate

*Hamard is a Visiting Professor at Universidad Autónoma de Madrid where he is on


leave from Universidad Metropolitana (Venezuela). **Lamothe is a Professor at
Universidad Autónoma de Madrid (Spain). Alfonso Hamard can be reached at:
alfonso.hamard@uam.es or ahamard@unimet.edu.ve; and Prosper Lamothe can be
reached at: prosper.lamothe@uam.es
1. INTRODUCTION

The capital asset pricing model, CAPM, currently represents the most used tool in
companies in order to calculate the discount rate to use when making an investment
decision in real assets (Graham and Harvey, 2001). However, CAPM is based on
hypotheses that are met in a bigger proportion in the capital markets of developed
countries. (Sabal, 2002: 113).

In the case of developed countries which operate with a different currency from the
country of origin, the exchange risk must be included, along with other factors, to the
investment adjustment rate, or the profitability demanded by the investor, but taking
into account that the theory of the purchasing power parity is (PPP)1 (Solnik, 1974,
2000). This implies that there wouldn’t be any exchange risk (Grauer, et al, 1976).

In the emerging countries, macroeconomic practices with the tendency to increase or


decrease the value of the currency for long periods of time can be observed. These
tendencies cannot be predictable, at least in the case of Latin American countries
(Hamard & Lamothe, 2006), being this the reason why investors are not capable of
adjusting the estimated received cash flows in order to decrease the adverse effects
of said policies. If, in addition, it is taken into account that there is a high correlation
index, which doesn’t allow a diversification of the investment, between the stock
market indices among the different countries in this area, the exchange risk rate can
be considered a systematic or non-diversifiable risk.

The aforementioned findings motivated us to formulate a cost of equity model to be


used for asset valuation in emerging markets that, additionally, takes into account
the systematic risk associated to the foreign exchange rate.

The proposed model, considers the difference between the market value of a
currency and the estimated value through the PPP theory, and it implies an
improvement to the Damodaran Model (2003), as it is revealed in its application to a
43 – companies sample which are part of the three stock market indices that exhibit
the highest market capitalization value in Latin America: Bovespa (Brazil), Mexbol
(Mexico) and IPSA (Chile).

2. BACKGROUND AND FRAMEWORK

Sharpe (1964) sustained that, in an equilibrium capital market, where there is no


information asymmetry nor transaction costs, all rational investors, having the same
transitory investment horizon, have the tendency of selecting the same portfolio,
called market portfolio, which contains a combination of all the financial assets with
risks that can be found in the capital markets. All the influence of the macroeconomic
factors that can act as systematic risks are reflected in the performance of the
market portfolio, which is commonly represented or approximated through the stock
market index.

1
The PPP (Purchasing Power Parity) theory establishes a direct relation between the type of
Exchange rate and the rate of inflation, so that the first one fluctuates in the same manner as the second
one.

2
By measuring the covariance between a specific asset and the index, the way that
the systematic risks affects the asset can be evaluated, being this way able to
evaluate which is the unearned margin contribution to the systematic risk due to this
asset; this risk is reflected as an increment or diminishment in the premium or
demanded performance rate, in addition to the risk–free rate.

If, in addition, one of the two following hypotheses are met: the investors have a risk
aversion degree determined by a quadratic function, or the stocks’ performance
follow a normal distribution, we find ourselves before the known market model or
CAPM, which establishes that the expected profitability of an asset [ E ( Ri ) ] is given
by the formula:

E ( Ri ) = R f + β i ( RM − R f )

where:

R f is the profitability offered by a risk free instrument


βi is the unearned margin contribution of the asset i to the systematic
market risk and it is measured by the formula:

Cov( Ri RM )
βi =
var( RM )

Cov ( Ri RM ) , is the co – variance between profitability of the asset i and the


profitability of the market portfolio M.
var( RM ) , is the variance of the market portfolio profitability.
RM , is the profitability of the market portfolio, usually represented by
the stock market.

The CAPM model takes the existence of a diversified stock market, where the
purchase or sell of an asset does not significantly affect other securities that are
quoted therein, being this condition met in fully developed markets. However, this
does not occur in Latin American emerging markets, where a high proportion of the
stock market index is represented by few companies (Table 1), being this the reason
why the variations in its stock market indices do not sum up the tendencies in the
macroeconomic environment, but only the factors that affect the companies with a
higher capitalization.

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Table 1. Latin American Stock Market Capitalization.
Stock Market Capitalization up to Weight of the 10 principal
Latin America 11-30-06 companies / Total weight of the
(in thousands of USD in millions) Stock Market Index (%)
Argentina 49.3 89.1
Brazil 656.9 49.3
Chile 166.2 66.2
Mexico 324.2 74.0
Own elaboration.
Sources: Federación Iberoamericana de Bolsas (2006); Bloomberg, LP.

The aforementioned explanation has led to the development of an increasing


number of research studies aimed to finding out which variables are significant for
assets valuation in emerging markets, and to the formulation of different valuation
models that include them.

2.1 Assets valuation in International Capital Markets

When investment opportunities are valued in countries different to the country where
the investor is located, additional factors, besides the exclusively domestic ones,
must be considered (Adler and Dumas, 1983: 932; Solnik, 2000: 161) such as the
risk derived from the variation of the exchange rate, which is generated when said
rate is not proportionally adjusted to the differential of the inflation rate between the
country where the investment is done and the inflation in the country where the
investor resides. This is translated into exchange losses when the foreign currency
devaluates opposite to the currency of the investor or vice versa.

The existence of characteristics that are unique to the markets allows us to classify
them into integrated and segmented markets. Basically, a capital market is
integrated when a financial or real asset that is commercialized in different countries
maintains the same price, otherwise it is segmented.

The International CAPM (ICAPM), proposed by Solnik (1974) for estimating the cost
of equity demanded by investors in integrated international markets, is based on the
following assumptions:

• The investors located in different countries have identical consumption


portfolios.
• The prices, in real terms, of the consumer goods, are identical in all of the
countries; that is to say that the purchasing power parity (PPP) is met at any
moment of time.

When these assumptions are not met, we find ourselves with segmented
international markets and the application of the ICAPM is not immediate. Its
application requires taking into account not only the performance in the respective
currency, but also the currency gains and losses in relation to the local currency, in
which the investor is positioned, and also the possible deviations resulting from an
information asymmetry which contributes, in a higher or lower degree, to the
segmentation of the capital markets.

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2.2 CAPM Model applied to segmented International Capital Markets.

The contributions carried out for applying CAPM in segmented international markets
are diverse.

In this manner, Godfrey and Espinosa (1996: 80) argued that the applicable discount
rate to deduct the projects should contemplate two out of the three types of risks to
which a company, that decides to invest in an emerging country, is exposed:

• Political or sovereign risk: the difference between the yields of a bond issued
by the emerging country and the treasury bonds of the developed (or home)
country in which the investor is located.

• Commercial Risk: estimated through the relation between the volatility of the
local stock market and the volatility of the stock market of the home country.

.
The proposed model, assuming that U.S.A. is the home country, can be expressed
in the following way:

E ( Ri ) = RFUS + CRi + 0.6 * (σ i / σ m )( RUS − RFUS )

where

RFUS , represents the risk-free rate offered by the North American Treasury
bonds

CRi is the difference between the yields offered by the sovereign bond and a
similar one issued by the U.S. Treasury.

σ i / σ m , is the relation between the volatility of the local stock market versus
the volatility of the United States of America’s stock market. Godfrey and
Espinosa propose reducing it in a 40% to avoid adding twice the same type
of risk; to do this they based themselves in a study done by Erb, Campbell
and Harvey (1995) which states that the 40% of the stock market’s volatility
can be explained by the variability in the credit quality.

RUS − RFUS , is the risk premium represented by the difference between the
profitability of the U.S.A.’s market portfolio and the one offered by the North
American treasury bonds.

Additionally, Godfrey and Espinosa propose that the third type of risk, the exchange
rate risk, should be considered in order to transfer the cash flows of the investor’s
currency through the use of forward Exchange rates (forward) or exchange rates
adjusted by the theory of purchasing power parity (PPP due to the initials in English.)

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Estrada (2000) suggests estimating the cost of equity through the use of a CAPM
model based in the semi-variance or standard semi-deviation2 with respect to the
mean, defined as:

∑ = (1 / T )∑t =1 ( Rt − E ( R )) 2
T
E(R) ∀Rt 〈 E (R )

where:

Rt, is the return rate during the term t


T is the number of observations in the sample
E(R), is the mean of the estimated returns during term T

When considering the perspective of an investor, located in U.S.A., who has an


internationally diversified portfolio, the model proposed by Estrada (2000: 20)
considers that the discount rate to apply for projects located in the country i [ E ( Ri ) ]
would be:

E ( Ri ) = RUSA + ( RPW )(
∑ E ( Ri )
)
∑ E ( Rw)
where:
RUSA , is the risk-free rate in the U.S.A.
RPW , is the risk premium based in the world market portfolio
∑ E ( Ri )
, is the relation between semi–deviations of the country i regarding
∑ E ( Rw)
the corresponding world portfolio.

Sabal (2002: 120-125) argues that country risk, on the one hand, may not be the
same for every industrial sector of an emerging country; and, on the other hand, it is
not, necessarily, a systematic risk; for this reason, Sabal suggests that country risk
should not be included in the equity cost. Sabal develops a modified version of
CAPM, whose main characteristic is that it does not explicitly include country risk in
the discount rate. The model proposed by Sabal, is given by:

E ( R p ) = R F + β p [ E ( Rm ) − R F ]

where:
RF is the yield of a Treasury Bond (in USD) with a maturity date similar to the
project.

2
To justify the use of semi–deviation, Estrada bases his work in empirical evidence found by Harvey
(2000) and Estrada (2001).

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E ( RM ) is the expected return rate of the proxy of the market’s portfolio; for
example, the stock market index of Standard & Poors 500 from U.S.A.
β p is an estimated beta as of the beta sector of the country of origin and the
local betas with respect to the parent company, weighting these betas by the
incomes obtained in every country where the company operates (Sabal,
2000: 124)

Damodaran (2003) sustains that the recent increase of the correlation degree among
the emerging countries causes that a part of the country risk cannot be diversified.
Therefore, he proposes to calculate the country risk premium through the factor
σ stock _ market
, as follows:
σ sovereign _ bond

σ stock _ market
CountryRisk = [E (RSB ) − E (RBUSA )]⋅
σ sovereign _ bond
where:

E ( RSB ) , is the profitability of the sovereign bond, issued by the emerging


country.
E ( RBUSA ) , is the profitability of a treasury bond from the U.S.A with a similar
maturity.
σ stock _ market , is the volatility of the emerging country’s stock market

σ sovereign _ bond , is the volatility of the emerging country’s sovereign bond

To quantify the degree of risk exposure, Damodaran (2003: 18) suggests the use of
a factor named λ j which is obtained from the regression between the asset
profitabilityj over the profitability of the emerging country’s sovereign bond.

Finally, he concludes by proposing the following model to estimate the adjustment


rate required in order to invest in an emerging country:

E ( R j ) = R f + β ( RM − R f ) + λ j (CountryRisk )

In table 2 we summarized some of the most important research studies for the
application of the CAPM at an international level.

In the models proposed by Solnik (1974), Grauer, Litzenberger and Stehle (1976),
Stehle (1977), Sercu (1980) and Adler and Dumas (1983) the Exchange risk is
explicitly considered; however, their focus is directed to integrated capital markets.

In the rest of the models analyzed, even though they can be applied to value
companies in segmented markets, such as the ones that exist in Latin American
emerging countries, the exchange risk within the discount rate is not explicitly
considered, with the exemption of the model made by Godfrey and Espinosa (1996),

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who sustain that the exchange rate risk can be diversified, and, therefore, should not
be a part of the discount rate.

It is important to remark that this last model only estimated the discount rate at
country level and not in the industry level, thus, it would be convenient to analyze
adding an additional factor to “adjust” this rate in accordance to the industrial sector
to which the studied project or company belongs, like Sabal (2002) and Damodaran
(2003) considered doing.

Table 2. Application of CAPM at an international level


Author Type of study Comments
Solnik (1974) Broadens the domestic CAPM model to include the Exchange It is estimated that the most
risk. Relaxing the restriction according to which: favorable investing strategy
- Investors have identical purchasing portfolios. consists in a common portfolio +
- Real prices of consuming goods are the same in every country; individual portfolio that reduces
that is to say, that the PPP theory is met at any time. exchange parity risk.
Grauer, Proves that if the PPP is sustained, the exchange risk does not Broadens the domestic CAPM
Litzenberger exist and; therefore, only one factor, the co- variance along with model, but assumes that PPP
and Stehle the World market portfolio, is enough to value an asset in theory holds.
(1976) equilibrium conditions.
Stehle (1977) Uses a regression on quadratic minimums generalized in Proofs do not give statistically
monthly stock data from NYSE in a period between 1956-1975 significant results either way.
to find out the degree of segmentation necessary for the domestic
CAPM to function better than the Grauer, Litzenberger and
Stehle (1976) model based in international factors
Sercu (1980) Broadens the domestic CAPM model to include the exchange Allows measuring the expected
risk, relaxing the restriction imposed by Solnik (1974) according asset returns based on its
to which the changes in the exchange rate were not correlated sensitivity to the world portfolio
with the assets return, in local currency. It assumes that there is changes plus the sensitivity to
no inflation, thus the nominal profitability is the same as the real the local market return and to the
profitability. local spot rates.
Adler and Broadens the CAPM model by considering three risk factors: Proposes an optimum strategy
Dumas market covariance, exchange risk and inflation rate risk to that consists in combining: a
(1983) explain the differences between the purchasing power and the world logarithmic portfolio and a
real profitability. domestic portfolio in order to
hedge local inflation.
Godfrey and CAPM Model to estimate the profitability in emerging countries Model, based in empirical
Espinosa must contemplate three types of risk: political, commercial and evidences from Erb et al (1995),
(1996) currency. directed to foreign direct
They propose including currency risk through adjustment to the investments in emerging
expected value in the cash flow. They consider that the sovereign markets.
risk is not diversifiable.

Estrada CAPM model based in the semi–variance; supported by empiric Profitability, given by the CAPM
(2000) evidence from Harvey (2000). model proposed, is more in
accordance with the equity cost
reported by empirical studies,
than the one estimated by the
CAPM model.
Sabal (2002) CAPM Model uses a weighted beta, which takes into account the It might be applied to the
betas in each of the countries related to the investment. valuation of real assets in
emerging markets. No empirical
evidence found yet

8
Damodaran CAPM Model considers that the country risk is partially Aimed at asset valuation in
(2003) diversified based in the relation between stock market volatility / emerging markets.
sovereign bond volatility.

3. DISCOUNT RATE AND COUNTRY RISK

One of the main risks that an international investor faces, according to previous
studies, is the risk of the exchange rate represented by the difference between the
official exchange rate of a country and the parity rate according to the PPP theory.
On this note, Rogoff (1996: 656) found some empirical evidence that PPP theory
holds, in the long run. Still, there is a certain risk for investments in real assets in
foreign currency, which materializes at the time when the exchange rate, in a
determined moment, significantly deviates itself from the PPP law.

Furthermore, the exchange rate risk can be translated into exchange losses, or
gains, for an investor at the moment of transforming his benefits from his local
currency or wanting to end the investment. This is the reason why, this factor must
be included in any model that is proposed in order to estimate the profitability rate
that discount future cash flows.

In order to include said risk, a factor based in the average of the deviation of the
observed parity vs. the theoretical parity that should prevail, at a determined
moment, could be used, if the exchange parity noted in the PPP theory, were met.
According to Rogoff (1996: 657-658) the general consensus, given by several
empiric studies, says that the deviations of the exchange rates in relation to the
equilibrium parity dictated by the PPP theory is not met in short terms, and said
deviations tend to decrease to an annual rate of 15%.

The deviations in respect to the parity can be positive or negative, and therefore, can
represent exchange losses or benefits, depending on the case. This should not have
a significant effect in the profitability of the investor in real assets if the deviations
had the tendency of compensating themselves in the medium term, that is to say, if
the deviations were symmetric regarding the exchange parity equilibrium on the long
term. However, a sustained tendency of devaluating the currency could cause
asymmetry in the distribution of the exchange risk which could present significant
losses in the return, in real terms, obtained by an investor located in a more
developed economy.

In order to quantify the type of exchange risk, it is necessary to estimate the


exchange rate that works as a reference to calculate the possible deviation between
the nominal rates observed and the rate that should rule at the given moment.

One of the most used theories for this is the Purchasing Power Parity, PPP, which
establishes that the exchange rate between the local currency and the foreign
currency shall be adjusted to reflect the level of changes in the prices (inflation rates)
of both countries.

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et (1 + ih ) t
=
e0 (1 + i f ) t

where:
i h , inflation rate of the country h (local)
i f , inflation rate of the country f (foreign)
e0 , is the price, in local currency, of a unit of the foreign currency at the
beginning of the term.
et , is the spot exchange rate in the term t

Usually, the following approximation is used to represent the aforementioned


formula:

e1 − e0
= ih − i f
e0

This expresses the variation of the exchange rate during a period, which should be
the same as the difference in the inflation rate during that same period of time. In
other words, PPP establishes that the currency with high inflation rates must
devaluate in relation to the currency with lower inflation rates. (Shapiro, 1998: 158-
159)

4. EXCHANGE RISK ANALYSIS: A PROPOSAL

In order to consider the risk associated to the type of exchange, one of the following
alternatives could be an option: on the one hand, having a model that allows
foreseeing which will be the effective exchange rate based on previous experience. If
it were feasible, the risk could be added in the estimate of the expected cash flows of
an investment. If this is not possible, and the exchange rate risk cannot be
diversified, it is necessary to add to the discount rate, a premium that reflects the
exchange rate risk that the foreign investor is taking.

Empiric evidence suggests that it is not possible to foresee the exchange rate upon
historical bases for Latin American emerging countries and, especially, in the case of
Latin American countries (Hamard & Lamothe, 2006), being this the reason why the
best mechanism to compensate for the risk taken by foreign investors in these
countries, is adding the exchange rate risk to the adjustment in order to discount the
expected cash flows.

As aforementioned in epigraph 2, the CAPM model considers that the investor can
diversify his investing portfolio in order to lower the risk, and this idea can be
broaden to the case of investors that operate in international markets, as it was
praised Solnik (1974) when he formulated ICAPM for integrated markets.

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However, the aforementioned authors do not agree about the way in which the
additional risk factors that a foreign investor incurs should be included; this is in
order to estimate the profitability of an investing project.

If every risk that cannot be minimized through a portfolio diversification is considered


systematic, as it was postulated by Markowitz (1952), then, the exchange rate risk in
Latin American is. This is due to, on the one hand, to historical tendency of sustained
devaluation, which is common to all the analyzed currencies. On the other hand, the
effects of the economic crisis in the most important emerging countries tend to
negatively affect, in a higher or lower degree, the rest of the Latin American
emerging countries. Finally, and as it is observed in table herein, there is a high
correlation degree among the main Latin American emerging stock markets. As a
consequence, we suggest that the exchange rate risk should be added to the equity
cost.3

Table 3. Correlation Matrix between the monthly closing prices of the stock market indexes
for Brazil (IBOV), Mexico (MEXB), Chile (IPSA), and the main developed stock market
indexes during the period from 28/04/00 to 31/05/07

Own elaboration. Source: Bloomberg, L.P.


Statistic value t > 4.59 (p-value = 0.00) in every case except in the case of IPSA (Chile) which has a
value of t = 2.21 (p-value = 0.03) with NKY (Japan)

A way of estimating the risk derived from the deviation of the currency’s market price
in regard to its PPP parity could be through a variance. However, this could also
suggest that deviations, regarding averages, are symmetrical, which does not occur
in any of the analyzed cases. On the contrary, a constant undervaluation of the local
currency in two of the three emerging countries was observed.

3
This inclusion, in the case of Latin American countries will only happen if the long term valuation,
because being this the case the currency price tends to approximate to the determined value by the PPP
theory. This does not happen in the short term, where the positive and negative fluctuations of the rate
usually cancel out each other.

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4.1 Proposed Model

Solnik (2000) defines the exchange rate risk based on an approximation of the parity
formula supported by the interest rate.4:

F = S(1+rdc)/(1+rfc)

where:
 F, is the nominal forward rate
 S, is the nominal spot rate
 rdc, is the local nominal risk free rate
 rfc, is the foreign nominal risk free rate

As a first degree lineal approach, it can be obtained:

(F-S)/S = rdc – rfc

In this case, the premium for the exchange rate risk is given by:

SRP = E[(S1-S0/S0]-(rdc-rfc)

Being this the first premium that the asset must offer, proportional to the exposure
degree or the sensitivity of its performance regarding the SRP variation.

The aforementioned approach is perfectly applied to integrated markets, where a


risk-free rate at a domestic level is known and accepted by the different economic
agents. However, this does not always occur in the scope of emerging capital
markets, where there isn’t either a domestic risk–free rate, or there isn’t a consensus
about the value that it should adopt.

If the rates in real terms are expressed, using for the formula done by Fisher, we
obtain:

(1 + RrDC )(1 + I DC )
F = Sx
(1 + RrFC )(1 + I FC )

where:

 RrDC domestic risk–free rate expressed in real terms


 RrFC foreign risk–free rate expressed in real terms
 I DC domestic inflation rate
 I FC foreign inflation rate.

4
The parity theory of the interest rates is based on the law of one price from the PPP theory, but
applied to the financial markets (Mascareñas, 2004: 94).

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In order to keep the exchange rate in real terms, it has to be adjusted by the relation
between the price levels of the two considered countries, expressed by the
consumer price index.

(1 + I DC )
F = Sx
(1 + I FC )

If it were no so, exchange differences in real terms would originate, this represents a
risk to the investors, which must be included in the discount rate.

The aforementioned risk can be expressed as the difference between the current
value of the exchange rate and the value that should be adopted to compensate the
differences in the inflation rates according to the PPP law, as Hamard and Lamothe
(2006) remark, there is a significant difference between the two before mentioned
values along the term of January – 93 and December 2006 in the case of the Latin
American countries, being this the reason why it is proposed to estimate said risk as
the difference between the geometric mean of both values, calculated during a
historical period similar to the estimated holding period.

On the other hand, the discount rate must also include the risk that the investor takes
when placing its resources in emerging countries, where a lower GDP per capita and
a lower degree of development of its capital markets exists. This type of risk is,
usually, reflected in what is known as the country risk differential.

Thus, the model proposed to calculate the demanded profitability for an emerging
Latin American country, from the perspective of an investor located in a country with
a developing capital market, in this case U.S.A., can be expressed as follows:

σ
E(Rj ) = RFUSA + β j [E(RMUSA ) − E(RFUSA )]⋅ (σstock
stock_ market

_ marketUSA
) + λ j Country_ Risk + γ j RDF

where:

 RFUSA , risk–free rate in the investor or origin country


 E ( RM USA ) − E ( RFUSA ) , asset market risk premium in the investor country
σ
 ( σ stockstock_ marketUSA
_ market
) , standard deviation of the local stock market, expressed in the
currency of the investor country, divided by the deviation of the standard
deviation of the stock market of the investor country
 Country _ Risk , difference between the yield offered by an emerging
sovereign bond and a treasury bond with a similar maturity from the country
of origin.
 RDF , risk premium of the foreign currency, estimated as the difference
between the annualized geometric mean of the currency market value and
the estimated value through its PPP.
 λ j , slope coefficient that is obtained from the regression between the asset
profitability j versus the sovereign bond profitability j.

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 γ j , sensitivity of the profitability, in the local currency of the asset j, to the
variations in the profitability of the currency in which the investor is
positioned5.

4.1.1 Selected sample and prediction error.

For the empirical comparison, we estimated the discount rate by the proposed
model, as well as by the Damodaran (2003) model versus the implicit discount rate.
To estimate the implicit rate of the asset, we based ourselves in the constant growth
model made by Gordon-Shapiro (1956); to do this, we estimated the internal rate of
return that equates the present value of all the expected cash flows to the closing
market price of the asset.

It is important to remark that the implicit rate estimated through the Gordon-Shapiro
(1956) model was based in the assumption that the analyzed companies are mature;
that is to say that its real option component is very small.

The selection of the Damodaran (2003) model as a comparison standard was based
on the following:

a) It reflects the risk factors that, in our opinion, affect more the assets value in
Latin American emerging markets.

b) Simplifies the free of ambiguity contrasting process because Damodaran


keeps available, in his web page, all of the steps taken in the application of
his model, and also all the partial and complete results obtained in order to
estimate the discount rate required of several Brazilian companies.

As a sample for the validation of the results, the assets of several companies that
are part of the three Latin American stock market indexes with higher stock market
capitalization: BOVESPA (Brazil), MEXBOL (Mexico) and IPSA (Chile) were
selected. Additionally, these markets were the three markets with the highest
reception of Foreign Direct Investment (FDI) during 2006, because they received
$45,774 million out of a total of $72,439 million, which is 63% of the total, in FDI for
all Latin America and the Caribbean.

5
Different from the free–of–range currency, observed in countries with a higher development, in
emerging countries have normally adopted a fixed Exchange rate plan or based in programmed
devaluations. Due to the fact that these plans rule most of studied period, the sensitivity of the asset
profitability in front of the fluctuation of the exchange rate is very difficult to acccurately estimate,
because, as an example, if we measure the co-variance between an asset profitability and another
which doesn’t vary, in this case represented by the Exchange rate profitability, the tendency for the
covariance will tend to be zero and so will the sensitivity.

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The selections of securities that belong to a stock market index present the following
advantages:

1. Operational efficiency, as a product of a high volume of transactions, which


indicates, with a higher accuracy, the sensitivity to the asset prices regarding
the macroeconomic variable movement that has an influence in the
registered securities price.

2. Information efficiency, because the issuing companies are analyzed by a


higher amount of financial agents, which is understood as a higher
disposition and reliability of the financial data which are necessary at the
moment of validating the results.

Companies that are part of the stock market of the three aforementioned countries
for a period between December 31, 2000 and December 31, 2006 were selected.
Subsequently, from the selected companies, those that presented free negative cash
flow or dividends equal to zero during the studied period were excluded. The reason
for doing this is the difficulty in applying the Gordon–Shapiro model in the cases
where the dividends or the cash flow are zero.

In general, the use of free cash flow for all the analyzed sectors was selected, with
the exemption of the banking sector, where the dividends to calculate the implicit
discount rate derived from the asset prices, were used.

The resulting sample is composed of 43 securities, discriminated as shown in the


following table:

Table 4. Sectors and Number of Securities in the Sample

COUNTRY INDUSTRIAL SECTOR # OF TOTAL


SECURITIES
Brazil Electricity and Gas 7
Metals – Steel 6
Banking 3
Beverages 2 18

Mexico Multi-Industry 5
Beverage 3
Banking 3
Construction 1 12

Chile Electricity and Gas 4


Food and Drinks 3
Banking 4
Distribution 2 13

15
For each of the 43 countries that are part of this sample, the predictive merit from the
Damodaran (2003) model versus the model proposed with the purpose to measure
the discount rate in each of the months within the period of December 31, 2000 and
December 31, 2006. For both models, it was assumed that the discount rate required
by the market could be implicitly estimated through the Gordon-Shapiro model using
the common monthly closing asset prices during the aforementioned period of time.

To estimate the forecasting errors, the following measures were used,

1. Mean Average Percentage Error, calculated as follows:

  y − yˆ i  
MAPE = (1 / n)absolute _ value  i 
  yˆ i  
Where:

yi = estimated value for the period i, through the Damodaran (2003) model or
through the model herein proposed.

ŷi = implicit value of the discount rate in the period i, estimated through the
Gordon-Shapiro model

n = number of observations in the sample

2. Root of Mean Squared error, calculated as:

yi − yˆ i 2
RMSE = (1 / n)( )
yˆ i
Where:

yi = estimated value for the period i


ŷi = implicit value derived from the market prices
n = number of observations in the sample

3. Theil’s U statistic: according to Greene (2000: 311) this forecasting error


measure is related to the determined coefficient (R2) but it isn’t bounded between
0 and 1. Like previous statistics, high values suggest poor performance in the
forecast; however, and not like previous ones, the U-Theil corrected the
performance scale that MAPE and RMSE had. Theil’s U can be estimated
through different ways, and herein, it is estimated according to the formula
proposed by Greene (2000: 310):

16
(1 / n)∑i( yi − yˆ i )
U=
(1 / n)∑ yi2

In which:

yi = estimated value for period i


ŷi = implicit value derived from market prices
n = number of periods for the sample

4.1.2 Validation Process.

To validate the results the following steps were taken:

1. Historical data corresponding to the monthly closing asset prices and


financial statement for the period of 200-2006 were compiled.

2. The unlevered beta value was calculated for a group of similar companies
from the same industrial sector, taking as entry data: published beta, the
relation between long term debt value / total equity share value, and the tax
rates. The mean of the beta value obtained was leveraged for each of the
Brazilian companies, basing it in its debt levels over capital and tax rates.

3. The country risk factor was estimated as the yield difference between by a
benchmark sovereign bond, with a maturity date of ten years, and the yield
offered by a U.S. treasury bond with a similar maturity date. In the case of
Brazil, Bond C was selected because it was one of the most representative
sovereign bonds and it also had one of the highest liquidity, indicated in USD
American dollars, which was commercialized in international markets during
the analyzed period of time.

4. The capital cost required by investors was calculated, based in the model
done by Damodaran (2003) and also based in this proposed model.

5. The costs of the implicitly required own resources were estimated, obtained
after having applied the asset valuation model based on constant growth,
taking as basis the free cash flows from stockholders, instead of the
dividends; the selection of the free cash flow is justified in the following
arguments:

a. Assumed valuation perspective, under which the investor located in


developed capital markets wants to participate in the process of
making decisions in the companies where he invests.

17
b. The discount on the cash flows techniques, just like the ones used for
dividends and for the benefits after taxes, lead, in the long term, to the
same relatively real results assumed (Lamothe, 1999: 104).

c. Companies which quote in the stock market showing a decreasing


tendency to pay dividends, according to study done by Fama and
French (2001) using data from stock markets (NYSE, AMEX,
NASDAQ) of the United States of America during the term of 1978 –
1999. The companies showed a tendency to decrease the payment of
dividends. The researchers found that this characteristic was not only
shared by small companies with a high potential for growth, but also
among the rest of the studied companies. The study, which included
financial and utility companies, renders that the percentage of
companies that paid dividends decreased from 66.5% in 1978, to
20.8% in 1999. These findings were also supported in an empirical
analysis about the tendency of dividend payment done by De Angelo,
De Angelo and Skinner (2004) using the same basis of financial data
(CRSP and Compustat) and a similar period of time, from 1978 to
2000.

d. The growing tendency to use assets buy–back as a flexible way of


increasing the profits per asset instead of increasing the payment of
dividends for the same purpose; this is part of the conclusions of a
survey that Brav, Graham y Michaelly (2005) did to the Chief
Financial Officers (CFO) of 384 companies.

e. Based on the aforementioned findings on the tendency to the


payment of dividends, the use of assets buy-back has become more
common in order to reflect the company’s results in the profits per
asset, Damodaran (2006:18) claims that the gap between paid
dividends and potential dividends has increased in order to correct the
problem that the use of dividends in cash for the dividend discount
model causes Damodaran (2006:19) proposes the usage of a
discounted dividend model based on potential dividends, which
should consider the asset buy–back as dividends. Because the asset
buy–back is not a periodic process, Damodaran (2006: 20)
recommends to use the average of the dividends and the buy-backs
done between four and five year period to obtain the payment
relationship that should be used in the dividend discount model.

The aforementioned arguments, combined with the evidence found by


Schiller (1981) that says that the volatility shown by asset prices were too
high to be explained by the dividend variation through time, led to the
dividend discount model, employed in the free cash flow instead of dividends.

6. Regression analysis were carried out using as independent variables the


values estimated through the aforementioned valuing models and, as
dependent variables, the implicit capital asset costs in the stock market and
financial companies historical data.

18
7. The comparison of the forecasting capacity of the models based in the
determined coefficients that resulted in the regression analysis carried out.

Calibration of the exposure degree of the asset to the exchange rate risk

In order to calibrate the exposure degree of an asset to the Exchange rate risk,
expressed by the Gamma parameter ( γ j ) in the proposed model, the following steps
were taken:

It was assumed that the exposure degree of an asset to the Foreign Currency Risk
(FCR), measured through the Gamma parameter ( γ j ) may vary in the different
industrial sectors, this could be caused, among other factors, to the degree of typical
leverage degree for each sector and market structure to which each product is
targeted.

A sensitivity analysis was made, using for it the data from the sample in order to
determine how a discount rate varies for each sector when the exposure degree
varies, this is estimated through the Gamma parameter ( γ j ), to the Foreign
Currency risk. It was supposed that the exposure degree that a market adopts must
be the same as the one which has the lowest forecasting error, based in MAPE and
Theil’s U, divided by the estimated rate through the proposed model and the derived
rate of the assets closing prices, in an implicit way.

Below, as an example, is the chart, which corresponds to the sensitivity analysis


done for the industrial sectors in Brazil.

19
Brazil
Prediction error (by industrial sector)

4.0
Mean Absolute Percentage Error

3.5

3.0

2.5
Electrical Util
(MAPE)

Metals
2.0
Banking
Beverages
1.5

1.0

0.5

0.0
-1.5 -1 -0.5 0 0.5 1 1.5
Gamma for RDF=31%

Figure 1. Brazil – Forecasting Error, estimated according to MAPE, for each


industrial sector

In the previous chart, based in MAPE’s the estimated error, we can observe that the
gamma to be used in the proposed model, for the electricity sector is equal to -0.2;
similar to the gammas that correspond to the metal, banking and drink sectors
whose gamma’s are equal to 0, -0.2 y 0.5 respectively.

20
4.1.3 Result analysis.

In the following table, the results obtained for 17 Brazilian companies, that are part of
our sample, are shown.

Table 5. Brazil – Comparison of the forecasting error from the proposed model vs.
The Damodaran (2003) model, based on the monthly closing prices in the period of
time between 12/2000 and 12/2006

Sector Company MAPEDam MAPEpro U TheilDam U Theilpro RMSEDam RMSEpro

Electricity Eletrobrás 1.4380 1.0054 1.0476 0.4678 21.5229 9.6282


Centrais El Sta Caterina 2.1202 1.2283 1.5233 0.7980 31.5834 16.6346
Gamma = Co Ener de Minas
0 Gerais 0.4578 0.4387 0.5372 0.4631 16.3556 14.1897
RDF = Co Paranaense de
30.95 Energia 1.4743 1.0126 1.7960 0.8929 25.3183 12.5887
Eletropaulo PNB 1.1547 0.5381 1.5647 0.6544 30.7241 12.8493
Trans Paulista PN 0.4263 0.2896 0.7101 0.3592 12.5923 6.4633
Comgas PNA 0.2992 0.2145 0.4208 0.3672 8.1588 7.1210
Media del Sector 1.0529 0.6753 1.0857 0.5718 20.8936 11.3536

Iron and
steel Cia Sider Nacional 0.4210 0.4725 0.4647 0.3505 21.7533 19.1513
Arcelor 0.3229 0.3827 0.4355 0.4116 15.6699 17.3288
Gamma =
0 Acesita S.A. 0.4438 0.3486 0.4619 0.4033 19.8459 17.0525
FCR =
30.95 Cia Vale do Rio Doce 0.3992 0.3204 0.4861 0.3482 15.7011 13.6201
Usinas Sider de Minas
Ger 0.5313 0.3901 0.5785 0.4711 48.6880 37.9683
Gerdau S.A. 0.4721 0.6259 0.6078 0.7632 20.3820 27.2603
Mean of the Sector 0.4317 0.4233 0.5058 0.4580 23.6734 22.0635

Financial Banco Bradesco S.A. 0.4782 0.2097 0.9240 0.2357 17.1723 4.4212
Banco Itau 0.9521 0.3750 1.8061 0.6247 23.0202 7.9246
Gamma =
0 Unibanco 3.4041 2.7098 4.5916 3.1445 34.5720 23.6604
FCR =
30.95 Mean of the Sector 1.6115 1.0982 2.4406 1.3350 24.9215 12.0021

Co de Bebidas das
Beverages Amer 0.806269 0.4619 0.8759 0.6708 101.9564 97.7915
Gamma =
1 Souza Cruz S.A. 0.561513 1.2545 0.9016 0.6714 67.3121 50.1635
FCR =
30.95 Mean of the Sector 0.683891 0.8582 0.8887 0.6711 84.6342 73.9775

21
In table 5, it is important to emphasize that the proposed model rendered a lower
forecasting error even when the gamma parameter used in three of the four
analyzed sectors is zero; in other words, the mean of the forecasting error of the
proposed model was lower even in the case that the investor didn’t explicitly discount
the exchange rate risk, as it can be observed in the electricity, banking and iron and
steel sector.

The proposed model gives a lower forecasting error, based in Theil’s U, in the
following cases:

Sector Lower Forecasting Error


Electricity 7/7 (100%)
Iron and Steel 6/7 (86%)
Financial 3/3 (100%)
Beverage 2/2 (100%)

Table 6. Chile - Comparison of the forecasting error from the proposed model vs.
The Damodaran (2003) model, based on the monthly closing prices in the period f
time between 12/2000 and 12/2006

Sector Company MAPEDam MAPEpro U TheilDam U Theilpro RMSEDam RMSEpro

Electricity Endesa Chile 0.5466 0.1587 0.5741 0.2156 11.0987 4.1850


Enersis 0.5882 0.3376 0.7705 0.6343 28.0735 23.0929
Gamma= 0.5 Colbun 0.3170 0.4073 0.4311 0.3854 5.8453 5.2631
FCR = 16.53 Almendral 1.9886 3.4091 0.7457 0.6735 18.6786 16.8707
Mean of the Sector 0.8601 1.0782 0.6304 0.4772 15.9241 12.3529

Embotelladora
Beverages Andina 0.5041 0.4901 0.5775 0.4906 10.8006 9.1766
Cervecerías Unidas 0.3177 0.3352 0.3458 0.2961 3.4938 3.0332
Gamma= 0.2 Viña Concha y Toro 0.2769 0.1161 0.3102 0.1349 3.2487 1.4082
FCR = 16.53
Mean of the Sector 0.3663 0.3138 0.4112 0.3072 5.8477 4.5393

Financial Banco de Chile 0.7543 0.7565 0.8699 0.8220 57.9024 54.7147


Banco de Crédito e
Invers 0.5359 0.2952 0.5448 0.3087 9.0040 5.1012
Gamma= 0.3 Corpbanca 0.2517 0.0416 0.3195 0.0699 3.8423 0.8460
FCR = 16.53 Banco Santander 0.2025 0.3990 0.2371 0.3896 2.2541 3.7381
Mean of the Sector 0.4361 0.3731 0.4928 0.3976 18.2507 16.1

Distribution Falabella 0.2874 0.5103 0.3252 0.5338 3.8768 6.3703


Gamma= - Distribución y
0.1 Servicio 1.1089 0.6803 0.7781 0.5121 5.7200 3.7623
FCR = 16.53
Mean of the Sector 0.6982 0.5953 0.5516 0.5230 4.7984 5.0663

22
In the case of Chile, the model proposed yields a lower forecasting error, based in
Theil’s U, for the following cases:

Sector Lower Forecasting Error


Electricity 4/4 (100%)
Beverage 3/3 (86%)
Financial 3/4 (75%)
Distribution 1/2 (50%)

Table 7. Mexico - Comparison of the forecasting error from the proposed model vs.
The Damodaran (2003) model, based on the monthly closing prices in the period of
time between 12/2000 and 12/2006

Gamma Company MAPEDam MAPEpro U TheilDam U Theilpro RMSEDam RMSEpro

Multi-
Industry Grupo Carso S.A. 0,4134 0,4676 0,6889 0,5864 24,8576 21,1602
Alfa S.A.B. 0,4377 0,4683 0,6697 0,5734 27,2142 23,2928
Gamma = 1,2 Grupo Electra 0,5989 0,5312 0,7740 0,6877 47,2252 41,9600
RDF = 7,3 Kimberly-Clark 0,5090 0,9158 1,8221 1,8452 10,8854 11,1131
Grupo Bimbo 0,3305 0,3610 5,1370 3,2125 10,4147 6,6006
Promedio Sector 0,4579 0,5488 1,8183 1,3810 24,1194 20,8253

Beverage Femsa SAB de CV 0,5365 0,2028 0,5879 0,3205 17,8910 9,7363


Gamma = 1,8 Grupo Modelo SA 0,5321 0,3968 0,7790 0,5613 22,4309 16,1952
RDF = 7,3 Embotelladora Arca 0,4368 0,3588 0,5552 0,3343 9,8831 6,1433
Promedio Sector 0,5018 0,3195 0,6407 0,4054 16,7350 10,6916

Financial Grupo Financ Banorte 0,4279 0,1815 0,5467 0,3556 11,9050 7,7532
Gamma = 1,1 Grupo Financ Inbursa 0,2629 0,6793 0,4053 0,5753 4,4455 6,4282
Grupo Financ
RDF = 7,3 Santander 0,5542 0,2126 0,5701 0,2392 11,5055 4,9472
Promedio Sector 0,4150 0,3578 0,5074 0,3900 9,2854 6,3762

Real Estate Corporación GEO 0,4410 0,2344 0,5066 0,2825 14,4930 8,0340
Gamma = 2 Promedio Sector 0,4410 0,2344 0,5066 0,2825 14,4930 8,0340

Finally, in the table above we can observe that the proposed model gives a lower
forecasting error, based in U-Theil, in the four analyzed sectors

In the analysis carried out it can be observed that the equity costs estimated through
the proposed model, in general show a lower forecasting error with the implicit equity

23
costs than those calculated through the Damodaran (2003) model for a 43-company
sample. However, these results to do not tip the balance, in any way, to either model
due, on the one hand, to the scarce number of historical financial data available; and
on the other hand to the use of historical data (ex –post) instead of using the data
estimated by economic agents. Given these reasons, said results can only be
considered as a first approach or guide to elaborate the design and execution of
validating studies that can be done further on.

Absence or Reliability of the Sample’s data

The scarcity of historical financial data, even in the case of the companies used in
the sample, evidences one of the most important difficulties that any research study
directed towards the analysis of the behavior of securities in emerging markets
faces. To this, the possible differences in the value of the dividend or cash flow that
can be in the financial data base, such as Bloomberg, Reuters and Thomson One
Banker, is added

5. Conclusions and recommendations

The preliminary results that were obtained suggest that for Latin American emerging
countries, exchange rate risk has to be considered as a systematic risk that has to
be added to the discount rate, due to the high correlation between stock market
indexes from the different countries and the impossibility of forecasting the exchange
rates in relation to strong currency.

Having this as an objective, a model is made, upon the basis of the one done by
Damodaran (2003) that recollects the foreign currency risk premium, and corrects
the market risk premium, and empirically verifying it when comparing it to the
aforementioned model. In it, the capital estimated costs from each model of constant
growth face each other, being this the reason why matured companies that belong to
three of the biggest capital markets in Latin America’s stock market index are
observed.

In order to empirically verify what was mentioned, the capital cost estimated
through proposed model versus the capital cost estimated through the Damodaran
(2003) model for a sample composed of 43 companies whose capital cost could be
susceptible to being implicitly estimated through the constant growth model were
studied. This led to a proposal of using it only to matured companies, whose real
option component is very small.

The results obtained, based on the forecasting error estimate using the Mean
Average Percentage Error (MAPE), Root of Mean Squared (RMSE) and U-Theil
statistic, showed that the proposed model has a lower forecasting error in relation to
the model suggested by Damodaran (2003).

The improvement in the forecasting error was kept even in the case of
several industrial sectors in Brazil, where the gamma parameter, which considers
exchange rate risk, had the result of being equal to zero. In other words, the

24
proposed model gave a lower forecasting error even without considering the
exchange rate risk.

The empirical validation done leads us to believe that, for most of the
industrial sectors from the analyzed countries, the risk factor presented by the
exchange rate is currently being valued by Latin American emerging market’s
investor, as suggested by this proposed model.

At this moment, it is important to highlight that the aforementioned findings can only
be used as a motivation to carry out longitudinal studies, where ex – ante
information, allowing measurement with a bigger statistic importance, the merit f the
proposed model to forecast the discount rate required by the market in order to
adjust the assets cash flow, can be available.

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