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General Model where R f denotes risk-free rate, MRP the world market risk premium,
SR specific risk of the investment, and A some additional adjustment .
Four Different Models
 two inputs ( R f and by all four models
MRP ) on the basis of worldwide markets are shared
 two other inputs SR and A differ across the models
1.
The Lessard Approach
2.
The Godfrey-Espinosa Approach
3.
The Goldman Sachs Approach
4.
The SalomonSmithBarney Approach
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 measures specific risk ( SR ) as the product of a project beta ( β p
) and a country beta ( β c
):
SR where β p and β c capture the risk of industry and country, respectively.
 cost of equity when investing in industry p and country c is:

β p
( β c
) is estimated as the beta of the industry (country) with respect to the world market, and no further adjustment ( A is assumed to be zero)
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 Two adjustments with respect to CAPM:
1)
Adjusting R f by the yield spread of a country relative to the U.S. ( YS c
)
A = YS c
2)
Measuring risk as 60% of the volatility of local market relative to world market
( σ c
/ σ w
)
SR = (0.60)· ( σ c
/ σ
W
) where σ c and σ w are the standard deviation of returns of stock market of country c and world, respectively.
● cost of equity when investing in industry p and country c is:
● this model ignores the specific nature of the project, but all that matters is the country in which the foreign company invests
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● one adjustments with respect to Godfrey-Espinosa Approach :
●
●
● replacing 0.60 by one minus the observed correlation between the stock market and bond market of the country c .
SR = (1–

SB
)
· ( σ c
/ σ
W
) where

SB is the correlation between stock and bond markets .
● cost of equity when investing in country c is:



● intuition of the model

SB
= 0  no correlation, two sources of risk (stock and bond)

SB
= 1  YS c captures all relevant risk
0<

SB
<1  the model incorporates both risk from bond and stock markets, but not double counting sources of risk
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 account for the risk of investing in Specific Industry and/or Country
 adjustments with respect to previous models :
1)
2)
3)
Political risk (

1
: between 0 and 10)
Risk of accessing capital markets (

2
: between 0 and 10)
Financial importance of the project (

3
: between 0 and 10)
A = { (

1+

2+

3
) / 30}·
YS c



 intuition of the model

1 is a rough estimate of the likelihood of expropriation (e.g., oil industry)

2 is low for large firms and high for small undiversified firms

3 is low for large firms investing in relatively small projects and high for small firms investing in relatively large projects
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 intuition of the model
 worst scenario A = YS c
; the best case A = 0
 For example, a large international firm investing a small proportion of its capital in an industry unlikely to be expropriated ( A = 0)
 A small undiversified company investing a large proportion of its capital in an industry likely to be expropriated would have to incorporate a full adjustment for political risk ( A = YS c
)
 quantify SR (specific risk) with the project beta, then the cost of equity when investing in industry p and country c is:
 this model, different from three previous ones, can allow discount rate to depend on not only specific project but also the company
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