Risk Analysis and Project Evaluation: Campbell R. Harvey

Risk Analysis and
Project Evaluation

Campbell R. Harvey
Duke University
and
National Bureau of Economic Research
Project Appraisal and Risk Management (PARM)
Duke Center for International Development at the Sanford Institute
May 27-28, 2002
1. Cash Flow versus Discount Rate
2. Approaches to Cost of Capital Measurement
3. Recommended Framework
4. Comparison of Methods
5. Conversion of Cash Flows
6. Project Specific Adjustments
7. Conclusions

Risk Analysis and Project Evaluation
Plan
Basic Project Evaluation:
Forecast nominal cash flows
Currency choice (assume US$)
Decide what risks will be reflected in cash
flows and those in the discount rate
Beware of double discounting

1. Cash Flow vs. Discount Rate
Simple example:
Assume a simple project with expected
$100 in perpetual cash flows
If located in the U.S., the discount rate
would be 10% and
Value= $100/0.10= $1,000

Simple example:
However, project is not located in the U.S.
but a risky country
If we reflect the country risk in the discount
rate, the rate rises to 20%
Value = $100/0.20 = $500

Simple example:
If we reflect the country risk in the cash
flows, the value is identical
Value = $50/0.10 = $500

Our approach
We will propose methods that deliver
discount rates that reflect country risk.
As our example showed, it is a simple
matter of shifting the country risk from the
discount rate to the cash flows.

Our approach
Indeed, we will often do this.
That is, we will use quantitative methods to get a
measurement of country risk in the discount rate.
Use the country risk adjustment in the cash flows (and
adjust discount rate down accordingly).
Use Monte Carlo methods on cash flows rather than
cash flows and discount rate.

Many different approaches:
1. Identical Cost of Capital (all locations)
2. World CAPM or Multifactor Model (Sharpe-
Ross)
3. Segmented/Integrated (Bekaert-Harvey)
4. Bayesian (Ibbotson Associates)
5. Country Risk Rating (Erb-Harvey-Viskanta)
6. CAPM with Skewness (Harvey-Siddique)

2. International Cost of Capital
7. Goldman-integrated sovereign yield spread
model
8. Goldman-segmented
9. Goldman-EHV hybrid
10. CSFB volatility ratio model
11. CSFB-EHV hybrid
12. Damoradan
Identical Cost of Capital

Ignores the fact that shareholders require different
expected returns for different risks
Identical Cost of Capital

Risky investments get evaluated with too low of a
discount rate (and look better than they should)
Less risky investments get evaluated with too high
of a discount rate (and look worse than they are)
Hence, method destroys value
Avoid
World CAPM
Sharpes Capital Asset Pricing Model is the
mainstay of economic valuation
Simple formula
Intuition is that required rate of return depends on
how the investment contributes to the volatility of
a well diversified portfolio
World CAPM
Expected discount rate (in U.S. dollars) on
investment that has average in a country
= riskfree + b
i
x world risk premium
Beta is measured relative to a world portfolio
OK for developed markets if we allow risk to
change through time (Harvey 1991)
World CAPM

Strong assumptions needed
Perfect market integration
Mean-variance analysis implied by utility
assumptions
Fails in emerging markets

Returns and Beta from 1970
R
2
= 0.013
-0.1
0
0.1
0.2
0.3
0.4
0.5
-0.5 0 0.5 1 1.5 2 2.5 3
Beta
A
v
e
r
a
g
e

r
e
t
u
r
n
s
Should be a positive relation, with higher risk associated with higher return!
But perhaps we should look at a more recent sample of data.

Returns and Beta from 1990
R
2
= 0.0211
-0.1
0
0.1
0.2
0.3
0.4
0.5
-0.5 0 0.5 1 1.5 2 2.5 3
Beta
A
v
e
r
a
g
e

r
e
t
u
r
n
s
Still goes the wrong way - even with data from 1990!
World CAPM

OK to use in developed markets
May give unreliable results in smaller, less liquid
developed markets
Segmented/Integrated CAPM

CAPM assumes that markets are perfectly
integrated
foreign investors can freely invest in the local market
local investors can freely invest outside the local market
Many markets are not integrated so we need to
modify the CAPM

Bekaert and Harvey (1995)
If market integrated, world CAPM holds
If market segmented, local CAPM holds
If going through the process of integration, a
combination of two holds

Estimate world beta and expected return
= riskfree + b
iw
x world risk premium

Estimate local beta and expected return
= local riskfree + b
iL
x local risk premium

Put everything in common currency terms
Add up the two components.
CC= w[world CC] + (1-w)[local CC]
Weights, w, determined by variables that proxy for
degree of integration, like size of trade sector and
equity market capitalization to GDP

Weights are dynamic, as are the risk loadings and
the risk premiums
Downside: hard to implement; only appropriate
for countries with equity markets
Recommendation: Wait
Ibbotson Associates
(Recognized expert in cost of capital calculation)

Approach recognizes that the world CAPM is not
the best model
Ibbotson approach combines the CAPMs
prediction with nave prediction based on past
performance.
Ibbotson Associates
STEPS
1 Calculate world risk premium=U.S. risk premium
divided by the beta versus the MSCI world
2 Estimate country beta versus world index
3 Multiply this beta times world risk premium
Ibbotson Associates

4 Add in 0.5 times the intercept from the initial
regression. This additional premium represents
the compensation an investor receives for taking
on the considerable risks of the emerging markets
that is not explained by beta alone.
Ibbotson Associates

Gives unreasonable results in some countries
Only useful if equity markets exist
Ibbotson Associates does not even use it
Recommendation: Do not use this version.
Ibbotson has alternative methods available.
CAPM with Skewness

For years, economists did not understand why
people spend money on lottery tickets and horse
betting
The expected return is negative and the volatility
is high
Behavioral explanations focused on risk loving
CAPM with Skewness

But this is just preference for positive skewness
(big positive outcomes)
People like positive skewness and dislike negative
skewness (downside)
CAPM with Skewness

Most are willing to pay extra for an investment
that adds positive skewness (lower hurdle rate),
e.g. investing in a startup with unproven
technology
CAPM with Skewness

Harvey and Siddique (2000) tests of a model that
includes time-varying skewness risk
Bekaert, Erb, Harvey and Viskanta detail the
implications of skewness and kurtosis in emerging
market stock selection

CAPM with Skewness

Model still being developed
Skewness similar to many real options that are
important in project evaluation
Recommendation: Wait
Goldman-Integrated*

This model is widely used by McKinsey, Salomon
and many others.
Addresses the problem that the CAPM gives a
discount rate too low.
Solution: Add the sovereign yield spread
*J.O. Mariscal and R. M. Lee, The valuation of Mexican Stocks: An extension of the capital
asset pricing model to emerging markets, Goldman Sachs, June 18, 1993.
Goldman-Integrated

The sovereign yield spread is the yield on a U.S.
dollar bond that a country offers versus a U.S.
Treasury bond of the same maturity
The spread is said to reflect country risk
Goldman-Integrated

STEPS
Estimate market beta on the S&P 500
Beta times historical US premium
Add sovereign yield spread plus the risk free
Goldman-Integrated-EHV Hybrid

Goldman model only useful if you have sovereign
yield spread
Use Erb, Harvey and Viskanta model to fit ratings
on yield spread

Real Yields and Institutional Investor Country
Credit Ratings from 1990 through 1998:03
R
2
= 0.8784
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
0 20 40 60 80 100
Rating
R
e
a
l

Y
i
e
l
d
s

You just need a credit rating (available for 136
countries now) and the EHV model will deliver
the sovereign yield

Even adding this yield spread delivers a cost of
capital that is unreasonably low in many countries
While you can get the yield spread in 136
countries with the EHV method, you can only get
risk premiums for those countries with equity
markets
Goldman-Segmented

Main problem is the beta
It is too low for many risky markets
Solution: Increase the beta

Goldman-Segmented

Modified beta=standard deviation of local market
return in US dollars divided by standard deviation
of the US market return
Beta times historical US premium
Add sovereign yield spread
Goldman-Segmented

Strange formulation. The usual beta is:

Using volatility ratio implies that the
Correlation=1 !!

World
i
World i World i
dev Std
dev Std
n Correlatio Beta
.
.
, ,

Goldman-Segmented

No economic foundation for modification
No clear economic foundation for method in
general
Recommendation: Not recommended
CSFB
E[r
i
]=SY
i
+ b
i
{E[r
us
-RF
us
] x A
i
} x K
i

SY
i
= brady yield (use fitted from EHV)
b
i
= the beta of a stock against a local index

L. Hauptman and S. Natella, The cost of equity in Latin American, Credit Swisse First
Boston, May 20, 1997.
CSFB
E[r
i
]=SY
i
+ b
i
{E[r
us
-RF
us
] x A
i
} x K
i

A
i
=the coefficient of variation (CV) in the local
market divided by the CV of the U.S. market)
where CV = s/mean.
K
i
=constant term to adjust for the
interdependence between the risk-free rate and the
equity risk premium

CSFB

No economic foundation
Complicated, nonintuitive and ad hoc
Recommendation: Avoid

Damodaran

Idea is to adjust the sovereign spread to
make it more like an equity premium rather
than a bond premium

A. Damodaran, Estimating equity risk premiums, working paper, NYU, undated.
Damodaran

Country Sovereign Equity std. dev.
equity = yield x ------------------
premium spread Bond std. dev.
Damodaran
Advantage: Recognizes that you just cant
use the bond yield spread as a plug number
in the CAPM
Disadvantage: Assumes that Sharpe ratios
for stocks and bonds must be the same in
any particular country.
Country Risk Rating Model

Erb, Harvey and Viskanta (1995)
Credit rating a good ex ante measure of risk
Impressive fit to data
C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries,
Journal of Portfolio Management, 1995.

Erb, Harvey and Viskanta (1995)
Explore risk surrogates:
Political Risk,
Economic Risk,
Financial Risk and
Country Credit Ratings
Sources
Political Risk Services International Country Risk Guide
Institutional Investors Country Credit Rating
Euromoneys Country Credit Rating
Moodys
S&P
Political risk. International Country Risk Guide
% of
Individual % of
Political Points Index Composite
Economic expectations vs. reality 12 12% 6%
Economic planning failures 12 12% 6%
Political leadership 12 12% 6%
External conflict 10 10% 5%
Corruption in government 6 6% 3%
Military in politics 6 6% 3%
Organized religion in politics 6 6% 3%
Law and order tradition 6 6% 3%
Racial and nationality tensions 6 6% 3%
Political terrorism 6 6% 3%
Civil war 6 6% 3%
Political party development 6 6% 3%
Quality of the Bureaucracy 6 6% 3%
Total Political Points 100 100% 50%
Financial risk. International Country Risk Guide
Financial
Loan Default or unfavorable loan restructuring 10 20% 5%
Delayed payment of suppliers credits 10 20% 5%
Repudiation of contracts by governments 10 20% 5%
Losses from exchange controls 10 20% 5%
Expropriation of private investments 10 20% 5%
Total Financial Points 50 100% 25%
Economic risk. International Country Risk Guide
Economic
Inflation 10 20% 5%
Debt service as a % of exports of goods and services 10 20% 5%
International liquidity ratios 5 10% 3%
Foreign trade collection experience 5 10% 3%
Current account balance as a % of goods and services 15 30% 8%
Parallel foreign exchange rate market indicators 5 10% 3%
Total Economic Points 50 100% 25%
Overall Points 200 100%
International Country Risk Guide Risk Categories
Risk Category Composite Score Range
Very High Risk 0.0-49.5
High Risk 50.0-59.5
Moderate Risk 60.0-69.5
Low Risk 70.0-84.5
Very Low Risk 85.0-100.0
Institutional Investors Country Credit Ratings
OECD Emerging Rest of World
1979 1994 1979 1994 1979 1994
Economic Outlook 1 1 2 3 3 4
Debt Service 5 2 1 1 1 1
Financial Reserves/Current
Account
2 3 4 4 4 3
Fiscal Policy 9 4 9 7 6 6
Political Outlook 3 5 3 2 2 2
Access to Capital Markets 6 6 7 9 8 9
Trade Balance 4 7 5 5 5 5
Inflow of Portfolio Investment 7 8 8 8 7 8
Foreign Direct Investment 8 9 6 6 9 7
Ratings are correlated:
0
10
20
30
40
50
60
70
80
90
100
I
n
s
t
i
t
u
t
i
o
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a
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I
n
v
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o
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C
C
R
A
A
+
A
A
A
A
-
A
+
A
A
-
B
B
B
+
B
B
B
B
B
B
-
B
B
+
B
B
B
B
-
B
+
B
N
R
S&P Sovereign Ratings
0
10
20
30
40
50
60
70
80
90
100
E
u
r
o
m
o
n
e
y

C
C
R
A
A
+
A
A
A
A
-
A
+
A
A
-
B
B
B
+
B
B
B
B
B
B
-
B
B
+
B
B
B
B
-
B
+
B
N
R
0
10
20
30
40
50
60
70
80
90
100
I
C
R
G

C
o
m
p
o
s
i
t
e
A
A
+
A
A
A
A
-
A
+
A
A
-
B
B
B
+
B
B
B
B
B
B
-
B
B
+
B
B
B
B
-
B
+
B
N
R
Risk Measure Changes
II CCR ICRGC ICRGP ICRGF ICRGE
II CCR -0.03 0.01 0.03 -0.09
ICRGC 0.35 0.79 0.54 0.43
ICRGP 0.30 0.83 0.25 0.06
ICRGF 0.26 0.60 0.35 0.05
ICRGE 0.10 0.52 0.24 0.25
Risk Measure Levels
ICRG ratings predict changes in II ratings:
Attribute Coefficient T-Stat R-Square
ICRGC 0.2120 7.59 5.0%
ICRGP 0.1244 5.67 2.8%
ICRGF 0.0956 5.69 2.8%
ICRGE 0.0833 4.65 1.9%
Ratings predict inflation:
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 20 40 60 80 100
II Rating September 1996
I
n
f
l
a
t
i
o
n

e
x
p
e
c
t
a
t
i
o
n
s

f
o
r

1
9
9
7
Ratings correlated with wealth:
$0
$5,000
$10,000
$15,000
$20,000
$25,000
0 20 40 60 80 100
II ratings for 74 countries
P
e
r

c
a
p
i
t
a

r
e
a
l

G
D
P

Time-series of ratings:
0
10
20
30
40
50
60
70
80
90
100
1
9
7
9
1
9
8
0
1
9
8
1
1
9
8
2
1
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8
3
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9
4
1
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9
5
1
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9
6
1
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7
1
9
9
8
Switzerland Italy Kuwait Argentina

Returns and Institutional Investor Country Credit
Ratings from 1990
R
2
= 0.2976
-0.1
0
0.1
0.2
0.3
0.4
0.5
0 20 40 60 80 100
Rating
A
v
e
r
a
g
e

r
e
t
u
r
n
s
Fit is as good as it gets - lower rating (higher risk) commands higher
expected returns. Even in among US firms, our best model gets about
30% explanatory power.
Credit Rating Model

Intuitive
Can be used in 136 countries, that is, in countries
without equity markets
Fits developed and emerging markets
STEPS:

EVR = risk free + intercept - slope x Log(IICCR)
Where Log(IICCR) is the natural logarithm of the
Institutional Investor Country Credit Rating

Easy to use:
0%
10%
20%
30%
40%
50%
60%
70%
0
1
0
2
0
3
0
4
0
5
0
6
0
7
0
8
0
9
0
1
0
0
Rating
H
u
r
d
l
e

r
a
t
e
ICRGC IICCR:84 IICCR:79
Also predicts volatility:
R
2
= 0.5033
0%
10%
20%
30%
40%
50%
60%
70%
0 20 40 60 80 100
Institutional Investor Country Credit Rating
A
n
n
u
a
l
i
z
e
d

V
o
l
a
t
i
l
i
t
y
Fitted volatility:
0%
10%
20%
30%
40%
50%
60%
70%
80%
0
1
0
2
0
3
0
4
0
5
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Rating
E
x
p
e
c
t
e
d

v
o
l
a
t
i
l
i
t
y
IICCR:84 IICCR:79
And correlation.
R
2
= 0.6809
-20%
0%
20%
40%
60%
80%
100%
0 20 40 60 80 100
Institutional Investor Countyr Credit Rating
C
o
r
r
e
l
a
t
i
o
n

w
i
t
h

M
S
C
I

A
C

W
o
r
l
d

Fitted correlation.
-100%
-80%
-60%
-40%
-20%
0%
20%
40%
60%
80%
0
1
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2
0
3
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Rating
E
x
p
e
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t
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d

c
o
r
r
e
l
a
t
i
o
n

w
i
t
h

w
o
r
l
d
IICCR:84 IICCR:79
Asian Crisis.
0
10
20
30
40
50
60
70
80
90
100
J
a
n
-
9
7
M
a
r
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a
y
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u
l
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e
p
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a
r
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a
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u
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I
C
R
G

r
a
t
i
n
g
China Hong Kong India Indonesia
Korea Malaysia Pakistan Philippines
Singapore Taiwan Thailand Russia
Asian Crisis.
60
65
70
75
80
85
90
J
a
n
-
9
7
M
a
r
-
9
7
M
a
y
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u
l
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S
e
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a
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e
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I
C
R
G

r
a
t
i
n
g
Korea Malaysia Russia
Beginning of
crisis
Value of US$100
0
20
40
60
80
100
120
140
160
180
200
J
a
n
-
9
7
M
a
r
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M
a
y
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7
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u
l
-
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7
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e
p
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a
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a
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u
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S
e
p
-
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V
a
l
u
e

o
f

$
1
0
0
Beginning of
crisis
Value of local currency
(indexed at 100)
0
20
40
60
80
100
120
J
a
n
-
9
7
M
a
r
-
9
7
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a
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u
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e
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a
r
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8
M
a
y
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8
J
u
l
-
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8
S
e
p
-
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8
V
a
l
u
e

o
f

$
1
0
0
Beginning of
crisis
September 11 impacted the way that
business is conducted all over the world
(cannot be diversified away)
It is reasonable to expect that investors
demand a premium to compensate them
for new investment in ventures that are
now deemed riskier.

950
970
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1030
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S&P 500 September 2001
September 11
950
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September 2001
S&P 500 2001
80
280
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680
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1080
1280
1480
1680
1
/
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1
/
8
0
1
/
3
1
/
8
2
1
/
3
1
/
8
4
1
/
3
1
/
8
6
1
/
3
1
/
8
8
1
/
3
1
/
9
0
1
/
3
1
/
9
2
1
/
3
1
/
9
4
1
/
3
1
/
9
6
1
/
3
1
/
9
8
1
/
3
1
/
0
0
1
/
3
1
/
0
2
September 2001
S&P 500 1980-2002
Impact not as substantial as one might think
in advance.
Nevertheless, risk increased.
Initially, people thought more terror would
be soon to come.
As time elapsed, the probability of
additional terror decreased.

ICRG Political Risk Rating
60.0
65.0
70.0
75.0
80.0
85.0
90.0
95.0
A
p
r
-
0
1
M
a
y
-
0
1
J
u
n
-
0
1
J
u
l
-
0
1
A
u
g
-
0
1
S
e
p
-
0
1
O
c
t
-
0
1
N
o
v
-
0
1
D
e
c
-
0
1
J
a
n
-
0
2
F
e
b
-
0
2
M
a
r
-
0
2
United States
World
More impact on U.S. than average of other
countries.

Implies a small increase in the risk premium
in the U.S. (10bp) and a smaller increase in
world premium (2bp).

Graham-Harvey survey of the risk premium
during September 11 crisis.

Pre-Sept. 11 Post-Sept. 11
10-year premium
Mean premium 3.63 4.82
Disagreement volatility 2.36 3.03
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
35.00%
Argentina Mexico Thailand
CAPM
Ibbotson
EHV
GS-EHV
GS-Seg
CSFB-EHV
68%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
30.00%
Slovakia Pakistan United States
CAPM
Ibbotson
EHV
GS-EHV
GS-Seg
CSFB-EHV
537%
Excel version
Forward Rate
Intuitive (expected exchange rate levels)
Works fine for developed countries
In emerging markets, there are two problems
Data not readily available
Will reflect a risk premium
Forward Rate
Risk premium in forward rate will lead to double
discounting
Think of the forward rate as the difference
between two interest rates (local and U.S.).
This difference will tell us something about
inflation expectations
But the local interest rate also reflects a default
probability (sovereign risk)
Purchasing Power Parity
Simple theory: The exchange rate will depreciate
by the difference in the local inflation rate and the
U.S. inflation rate.
Empirical evidence shows this assumption works
well in emerging markets (but not that well in
developed markets)
Purchasing Power Parity
To operationalize, we need multiyear forecasts of
inflation in the particular country as well as the
U.S.
The difference in these rates is used to map out the
expected exchange rates
The expected exchange rates are used to convert
cash flows into US$
We then apply the US$ discount rate to US$ cash
flows
Project Risk Analysis
Operating Risk
Pre-completion
Post-completion
Sovereign
Financial Risk
Operating Risk
Precompletion
Resources available (quality/quantity)
Technological risk (proven technology?)
Timing risks (failure to meet milestones)
Completion risk
Handle in cash flows

Operating Risk
Post-completion
Market risks (prices of outputs)
Supply/input risk (availability)
Throughput risk (material put through plus
efficacy of systems operations)
Operating cost
Handle in cash flows

Operating Risk
Sovereign Risk (Macroeconomic)
Exchange rate changes
Currency convertibility and transferability
Inflation
Handle through discount rate

Operating Risk
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

Operating Risk
Sovereign Risk (Force Majeure)
Political events
Wars
Labor strikes
Terrorism
Changes in laws
Natural catastrophes
Hurricanes/earthquakes/floods

Financial Risks
Probability of default
Look at debt service coverage ratios and
leverage through life of project
Check to see if internal rate of return is
consistent with (at least) the financial risks


Conclusions
Project evaluation in developing countries is
much more complex than in developed
countries
Critical to: accurately identify risks and to
measure the degree of mitigation if any.
Each risks need to be handle consistently
either in the cash flows or the discount rate,
not both.

Risk Analysis and Project Evaluation: Campbell R. Harvey

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Risk Analysis and Project Evaluation: Campbell R. Harvey

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