!

Political Risk and

International Valuation"
"
"
Geert Bekaert, Columbia University!
Campbell R. Harvey, Duke University!
Christian T. Lundblad, University of North Carolina"
Stephan Siegel, University of Washington!
"
BCRP!
February 2012"
 Political Risk and the Valuation of!
Cross-Border Investments"
Given the increased volume of investments in emerging markets,
incorporating political risk into the valuation of cross-border
investments is important.!
!

For well-diversified international investors, theory suggests that

expected cash flows are discounted with discount rates reflecting
exposure to systematic risks (for example, the International CAPM)!
!

q  Political risks are accounted for in expected cash flows"

q  Discount rates are low since foreign markets offer diversification!

Textbook and professional advice consistently calls for an (ad hoc)

adjustment to the discount rate!
!
[NB: International asset pricing theory is still very much struggling here.]!

"
 Political Risk and the Valuation of!
Cross-Border Investments"

To evaluate a project, we need to measure net present

values:!
T
! E[CFt ]
!
NPV = ∑ t
− C0
t =1 (1 + k )
!
Where C0 represents the initial investment, CFt the cash
flow, and k the appropriate discount rate!
!
In an international context, expected cash flows and
discount rates can be hard to pin down!
!
!
 Common Adjustments of Discount Rate"
Proposed adjustments to discount rate typically rely on adding the
sovereign yield spread to the discount rate implied by theory.!
!

While many versions exist, let’s first focus on the most common case:!
!
!
!

! Discount Ratei , j ,t = rf ,t + β iʹ′,t λt + SS j ,t

where !
!

SS = yield of foreign country (j) government bond in USD less !!

!U.S. Treasury bond of similar maturity (typically around 10 years)!
!
! +" Timely, market-based, forward looking!

-" Is it a good proxy for political/country risk?!

 Applying Country Spreads "
to International Valuations"

q  The problem is here. We don’t know how to assign probabilities to

the political risk event:!

q  So, we wish to use an adjustment r*. This is ok, let’s just understand
what we are really doing. !

!
 Sovereign Spreads"
Spreads  over
U.S.  Treasuries

9
 Political Risk and the Valuation of!
Cross-Border Investments"
!
First, obtain cost of equity as if project in U.S….!
!
! ! ! ! E ⎡⎣ r!eUS−based ⎤⎦ =!! rf + βe ( E [rUS ] − rf )
!
Then, “add on” the risk of operating in, say, Peru using the
sovereign spread…!
!
!! E !"rePeru #$ = E !"reUS #$ + SS = E !"reUS #$ + rSPeru − rfUS
( )
!
!

10!
 Common Adjustments of Discount Rate"

Discount Ratei, j,t = rf ,t + g(Rw,t ) + f (SS j,t )

€
Comparison of a few methods"
 Outline"

Consider sovereign yield spreads, but instead decompose their

1"
relative importance into the constituent pieces of interest
(many papers)"

2" Political risk spreads extracted from sovereign yield spreads

(new)"

3" Better accounting for political risk in international valuation

(new)"
Problem: Commonality and Global Risk"
2,000.00

1,800.00 U.S. High Yield Spread (bp)

EMBI+ Composite Spread (bp)
1,600.00

1,400.00

1,200.00

1,000.00

800.00

600.00

400.00

200.00

0.00
 Sovereign Yield Spread Data and Samples"

Sovereign USD bond yield spreads (over same maturity Treasury bonds)!
!

•  monthly frequency!
•  44 countries!
•  between January 1994 and December 2009!
•  JP Morgan’s Emerging Market Bond Indices:!
1.  EMBI+ !most liquid bonds!
2.  EMBI !less liquid bonds!
3.  SSPRD !stripped spreads (collateralized debt net of value
! !of collateral)!

“Baseline sample” of 20 countries with at least 10 years of data"

!
!
“Out sample” of 24 countries for additional tests/applications"
 Sovereign Yield Spread Data and Samples"
Baseline Sample Out Sample
Mean Median Std. Dev. Obs. Mean Median Std. Dev. Obs.
Argentina 1,735.1 729.0 2,016.1 201 Algeria 803.1 722.0 404.8 48
Brazil 688.5 662.9 397.9 204 Belize 932.3 728.5 470.9 34
Bulgaria 604.7 511.5 516.8 186 Chile 147.0 144.6 69.7 128
China 108.0 104.4 50.1 190 Croatia 295.2 214.0 192.6 97
Colombia 424.0 408.3 211.3 155 Dominican Rep. 607.5 485.3 398.1 98
Cote d'Ivoire 2,336.8 2,483.5 756.6 121 Egypt 188.5 141.1 137.6 102
Ecuador 1,339.4 1,091.0 929.3 179 El Salvador 307.1 274.4 147.6 93
Lebanon 427.1 379.0 209.9 141 Gabon 625.1 481.4 306.9 25
Malaysia 190.3 159.0 146.7 159 Ghana 712.5 556.9 373.3 27
Mexico 395.1 355.5 263.7 204 Hungary 108.6 75.2 105.7 132
Morocco 474.4 439.0 281.2 155 Indonesia 323.9 285.7 168.9 68
Nigeria 1,237.9 1,284.0 720.1 171 Iraq 625.3 544.8 216.0 46
Panama 345.4 353.2 117.4 162 Jamaica 664.4 684.2 268.4 27
Peru 407.3 409.0 206.9 154 Kazakhstan 626.7 484.6 348.7 31
Philippines 425.6 423.3 161.7 204 Pakistan 625.8 438.3 548.8 89
Poland 202.3 181.0 154.3 183 Serbia 365.9 292.0 242.7 57
Russia 897.9 406.7 1,285.0 149 South Korea 170.7 113.4 141.2 125
South Africa 231.0 210.4 136.6 181 Sri Lanka 1,007.1 764.1 551.0 26
Turkey 451.8 381.0 238.6 163 Thailand 156.7 128.1 127.6 107
Venezuela 889.5 841.0 483.0 204 Tunisia 174.6 147.0 106.9 92
Trinidad & Tobago 211.3 183.5 74.4 12
Ukraine 744.3 354.6 739.4 116
Uruguay 496.8 364.0 331.0 104
Vietnam 287.5 197.6 194.3 50
 Determinants of Sovereign Yield Spreads"

Global (U.S.)! Co-movement of sovereign spreads (SS) and Credit

Default Swaps (CDS) [Mauro, Sussman, Yafeh (2002); Gonzalez-
Rozada and Levy-Yeyatti (2008), Remolana, Scatigna, Wu (2008), Longstaff,
Pan, Pedersen, Singleton (2011)]!
!

è U.S. Corporate High Yield Spread over Treasuries!

Liquidity! Liquidity [Hund and Lesmond (2008); Martell (2009)]!

!
èDaily zero returns per month (12-month moving average)!

Local! Local macro-economic conditions [Hilscher and Nosbusch

(2010); Ozatay, Ozmen, and Sahinbeyogu (2009)]!
!
è ICRG Economic and Financial Risk Indicator !
(log of US (low risk) – country (high risk))!
!
Political Risk! è ICRG Political Risk Indicator !
(log of US (low risk) – country (high risk))"
 Political Risk"

Political Risk – EMs are defined by heavily politicized

economic and regulatory environments!
!
Ø  Expropriation (Russia, Venezuela, & Zimbabwe) !
Ø  Regulatory Discrimination (China)!

Ø  Contract Repudiation & Separation of Ownership/Control!

Ø  Corruption and Legal Inefficiency !
Ø  Political Unrest and Terrorism!
Ø  Home-country Restrictions and Exchange Controls!
!
T
E[CFt ]
NPV = ∑ t
− C0
t =1 (1 + k )
 Measuring Political Risk"

International Country Risk Guide (ICRG)"

 Measuring Political Risk"

21
Source: Political Risk Services
 Measuring Political Risk"

Source: Political Risk Services

22
 Empirical Framework"

Specification!
SS j ,t = c0 + c1ʹ′Global t + c 2ʹ′ ZR j ,t + c3ʹ′Local j ,t + c 4PR j ,t + ε j ,t

Global! U.S. Corporate High Yield Spread less Treasury yield"

ZR! •  Average illiquidity of sovereign bonds in country j less U.S.!

•  Average life of sovereign bonds in country j!

Local! ICRG Economic + Financial Risk in USA less ICRG Economic +

Financial Risk in country j "
PR! ICRG Political Risk in USA less ICRG Political Risk in country j"
Estimation!
•  Pooled OLS!
•  Standard errors corrected for heteroskedasticity and correlation across
time and across countries!
Explaining Sovereign Spreads"

ßRealized Sovereign Bond Market Volatility!

 Predicting Sovereign Spreads: Mexico"
1800
Figure 2a

1600

1400
Mexico: EMBI Spread

1200
Mexico: Predicted Spread
1000

800

600

400

200

0
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
-200
Predicting Sovereign Spreads: South Africa"
Overall Fit"
Overall Fit"
 Variance Decomposition"

R2 captures explanatory power of all RHS variables:"

where"
2 Var (SS )
R =
Var (SS ) SS j ,t = cˆ0 + cˆ1ʹ′Global t + cˆ2ʹ′ ZR j ,t + cˆ3ʹ′Local j ,t + cˆ4PR j ,t

Contribution of Political Risk (PR) to predicted Sovereign Spread (SS):"

Cov (SS, cˆ4PR )

Var (SS )

Maximal contribution of Political Risk (PR) to predicted SS:"

1.  Orthogonalize illiquidity, Local Macro, and Bond Volatility w.r.t. PR!
2.  Re-estimate Model!
3.  Decompose Variance!
Variance Decomposition: Results"
 Extracting Political Risk Spreads"

q  Political Risk is only one (of many) determinant of Sovereign Yield
Spreads!

q  We could use c4PRj,t as Political Risk Spread for country j!

q  But we would miss potentially important pricing errors. Therefore:!

cˆ4PR j ,t
NPRSS j ,t = SS j ,t
SS j ,t

q  For maximal effect of Political Risk, we use estimate after

orthogonalizing other determinants with respect to Political Risk!
cˆ4ORTH PR j ,t
WPRSS j ,t = SS j ,t
SS j ,t
 Narrow and Wide Political Risk Spreads"

ICRG Political Risk Predicted c 4 PR i,t c 4 PR i,t Narrow Wide EMBI

Distribution SS i,t (Narrow) (Wide) Ratio Ratio Spread NPRSS i,t WPRSS i,t

0.90 732.03 245.62 774.89 0.43 0.91 742.08 318.05 672.63

0.75 561.82 181.02 571.11 0.45 0.86 548.82 247.08 471.59
0.50 462.29 122.74 387.24 0.37 0.82 469.73 174.23 383.06
0.25 346.84 73.34 231.37 0.35 0.71 348.49 121.64 248.76
0.10 229.95 41.95 132.35 0.28 0.60 263.83 73.46 159.45

For a target country with median political risk, extracted political

risk spreads are between 37 and 82% of full sovereign yield spread!
 Sovereign Yield and Political Risk Spreads!
(for December 2009)"

EMBI Narrow Wide EMBI Narrow Wide

Country Spread Ratio NPRSS i,t Ratio WPRSS i,t Country Spread Ratio NPRSS i,t Ratio WPRSS i,t
Argentina 659.7 0.11 75.4 0.36 237.9 Lebanon 286.9 0.44 126.3 1.00 286.9
Brazil 188.5 0.27 50.4 0.84 159.1 Mexico 192.1 0.25 48.0 0.79 151.3
Bulgaria 178.5 0.36 64.2 1.00 178.5 Pakistan 687.7 0.23 156.1 0.72 492.5
Chile 95.4 0.40 38.5 1.00 95.4 Panama 166.4 0.20 32.8 0.62 103.6
China 64.2 0.52 33.6 1.00 64.2 Peru 164.5 0.42 68.9 1.00 164.5
Colombia 198.2 0.41 80.5 1.00 198.2 Philippines 205.6 0.36 73.7 1.00 205.6
Dominican Rep. 405.3 0.19 76.6 0.60 241.8 Poland 124.2 0.08 10.0 0.25 31.5
Ecuador 769.5 0.20 155.2 0.64 489.6 Russia 203.4 0.28 57.2 0.89 180.3
Egypt 41.9 1.00 41.9 1.00 41.9 Serbia 333.4 0.22 74.7 0.71 235.5
El Salvador 326.1 0.25 80.7 0.78 254.7 South Africa 149.5 0.40 59.9 1.00 149.5
Gabon 389.7 0.23 90.4 0.73 285.1 Sri Lanka 382.2 0.15 59.0 0.49 186.3
Ghana 462.3 0.16 75.0 0.51 236.5 Turkey 196.5 0.32 63.6 1.00 196.5
Hungary 185.6 0.18 33.5 0.57 105.6 Ukraine 989.1 0.15 146.9 0.47 463.6
Indonesia 230.3 0.21 49.1 0.67 155.0 Uruguay 238.4 0.22 52.3 0.69 165.1
Iraq 446.8 0.38 171.3 1.00 446.8 Venezuela 1040.6 0.31 322.3 0.98 1016.8
Jamaica 719.1 0.10 73.2 0.32 230.9 Vietnam 313.8 0.17 53.2 0.54 167.9
Additional Political Risk Spreads!
(for December 2009)"
 Applying Political Risk Spreads to
International Valuations"
q  Recall, we don’t know how to assign probabilities to the political risk
event:!

q  So instead we use the appropriate adjustment, r*.!

q  Given our methodology, we extract the component of the sovereign

spread that is attributable to political risk. Use for an adjustment:!

q  Do recall, however, that the employed adjustment implies a political

risk probability!!
 Sample Calculations"

Assume: NPRSS represents Political Risk

Political Risk Promised Political Risk Cumulative Adjusted Discount
(percentile) Sovereign Yield Probability Probability Rate of 15%
(p ) (at maturity)

90th 1,254.08 2.83% 24.92% 18.34%

75th 1,060.82 2.23% 20.22% 17.63%
50th 981.73 1.59% 14.78% 16.85%
25th 860.49 1.12% 10.65% 16.30%
10th 775.83 0.68% 6.61% 15.79%

Assume: SS represents Political Risk

Political Risk Promised Political Risk Cumulative Adjusted Discount
(percentile) Sovereign Yield Probability Probability Rate of 15%
(p ) (at maturity)

90th 1,254.08 6.59% 49.45% 23.12%

75th 1,060.82 4.96% 39.89% 21.00%
50th 981.73 4.28% 35.41% 20.14%
25th 860.49 3.21% 27.83% 18.81%
10th 775.83 2.45% 21.95% 17.89%
Case Study: Power Generation in Pakistan!
HBS Case AES; Desai (2006)"
 Conclusions"

Accounting for political risk plays an important role in cross-border

investment decisions and thereby affects the global allocation of capital"
!
Existing approaches adjust discount rates by adding the target
country’s sovereign yield spread"
!
Most variation in sovereign yield spreads is NOT due to variation in
political risk"
!
An extracted (Narrow) Political Risk Spread is about 30% of the total
sovereign spread"
!
Implied risk event probabilities are less than half using (Narrow)
Political Risk Spreads instead of Sovereign Yield Spreads!
!
!