May 2006
Risk Analysis and
Project Evaluation
Campbell R. Harvey
Duke University
and
National Bureau of Economic Research
Risk Analysis and Project Evaluation
Plan
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Cash Flow versus Discount Rate
Approaches to Cost of Capital Measurement
Recommended Framework
Comparison of Methods
Conversion of Cash Flows
Industry Adjustments
Project Specific Adjustments
Risk Worksheet
Conclusions
Appendices
2
Risk Analysis and Project Evaluation
1. Cash Flow vs. Discount Rate
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
3
Risk Analysis and Project Evaluation
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
4
Risk Analysis and Project Evaluation
1. Cash Flow vs. Discount Rate
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
5
Risk Analysis and Project Evaluation
1. Cash Flow vs. Discount Rate
Simple example:
• If we reflect the country risk in the cash
flows, the value is identical
Value = $50/0.10 = $500
6
Risk Analysis and Project Evaluation
1. Cash Flow vs. Discount Rate
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.
7
Risk Analysis and Project Evaluation
1. Cash Flow vs. Discount Rate
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.
8
Risk Analysis and Project Evaluation
2. International Cost of Capital
Many different approaches:
1. Identical Cost of Capital (all locations)
2. World CAPM or Multifactor Model (SharpeRoss)
3. Segmented/Integrated (Bekaert-Harvey)
4. Bayesian (Ibbotson Associates)
5. Country Risk Rating (Erb-Harvey-Viskanta)
6. CAPM with Skewness (Harvey-Siddique)
9
Risk Analysis and Project Evaluation
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
10
Risk Analysis and Project Evaluation
2. International Cost of Capital
Identical Cost of Capital
• Ignores the fact that shareholders require different
expected returns for different risks
11
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
12
Risk Analysis and Project Evaluation
2. International Cost of Capital
World CAPM
• Sharpe’s 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
13
Risk Analysis and Project Evaluation
2. International Cost of Capital
World CAPM
• Expected discount rate (in U.S. dollars) on
investment that has average in a country
= riskfree + bi 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)
14
Risk Analysis and Project Evaluation
2. International Cost of Capital
World CAPM
• Strong assumptions needed
• Perfect market integration
• Mean-variance analysis implied by utility
assumptions
• Fails in emerging markets
15
Risk Analysis and Project Evaluation
2. International Cost of Capital
Returns and Beta from 1970
0.5
Average returns
0.4
2
R = 0.013
0.3
0.2
0.1
0.0
-0.5
-0.1
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Beta
Should be a positive relation, with higher risk associated with higher return!
16
But perhaps we should look at a more recent sample of data.
Risk Analysis and Project Evaluation
2. International Cost of Capital
Returns and Beta from 1990
0.5
Average returns
0.4
2
R = 0.0211
0.3
0.2
0.1
0.0
-0.5
-0.1
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Beta
Still goes the wrong way - even with data from 1990!
17
Risk Analysis and Project Evaluation
2. International Cost of Capital
World CAPM
• OK to use in developed markets
• May give unreliable results in smaller, less liquid
developed markets
18
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
19
Risk Analysis and Project Evaluation
2. International Cost of Capital
Segmented/Integrated 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
20
Risk Analysis and Project Evaluation
2. International Cost of Capital
Segmented/Integrated CAPM
Estimate world beta and expected return
= riskfree + biw x world risk premium
Estimate local beta and expected return
= local riskfree + biL x local risk premium
21
Risk Analysis and Project Evaluation
2. International Cost of Capital
Segmented/Integrated CAPM
• 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
22
Risk Analysis and Project Evaluation
2. International Cost of Capital
Segmented/Integrated CAPM
• 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
23
Risk Analysis and Project Evaluation
2. International Cost of Capital
Ibbotson Associates
(Recognized expert in cost of capital calculation)
• Approach recognizes that the world CAPM is not
the best model
• Ibbotson approach combines the CAPM’s
prediction with naïve prediction based on past
performance.
24
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
25
Risk Analysis and Project Evaluation
2. International Cost of Capital
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.”
26
Risk Analysis and Project Evaluation
2. International Cost of Capital
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.
27
Risk Analysis and Project Evaluation
2. International Cost of Capital
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”
28
Risk Analysis and Project Evaluation
2. International Cost of Capital
CAPM with Skewness
• But this is just preference for positive skewness
(big positive outcomes)
• People like positive skewness and dislike negative
skewness (downside)
29
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
30
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
31
Risk Analysis and Project Evaluation
2. International Cost of Capital
CAPM with Skewness
• Model still being developed
• Skewness similar to many “real options” that are
important in project evaluation
Recommendation: Wait
32
Risk Analysis and Project Evaluation
2. International Cost of Capital
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.
33
Risk Analysis and Project Evaluation
2. International Cost of Capital
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”
34
Risk Analysis and Project Evaluation
2. International Cost of Capital
Goldman-Integrated
STEPS
• Estimate market beta on the S&P 500
• Beta times historical US premium
• Add sovereign yield spread plus the risk free
35
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
36
Risk Analysis and Project Evaluation
2. International Cost of Capital
Real Yields
Real Yields and Institutional Investor Country
Credit Ratings from 1990 through 1998:03
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
2
R = 0.8784
0
20
40
60
80
100
Rating
37
Risk Analysis and Project Evaluation
2. International Cost of Capital
ICRG as a Function of Sovereign Spread
Data through December 2005
100
90
y = -4.997x + 98.186
R2 = 0.4451
80
ICRG-C
70
60
50
40
30
20
10
0
0
1
2
3
4
5
6
Ln(Sovereign Spread)
7
8
9
10
38
Risk Analysis and Project Evaluation
2. International Cost of Capital
ICRG Political as a Function of Sovereign Spread
Data through December 2005
100
90
y = -4.9061x + 95.552
R2 = 0.272
80
ICRG-P
70
60
50
40
30
20
10
0
0
1
2
3
4
5
6
7
8
9
10
Ln(Sovereign Spread)
39
Risk Analysis and Project Evaluation
2. International Cost of Capital
ICRG Economic as a Function of Sovereign Spread
Data through December 2005
50
y = -2.2626x + 48.103
R2 = 0.2377
45
40
ICRG-E
35
30
25
20
15
10
5
0
0
1
2
3
4
5
6
Ln(Sovereign Spread)
7
8
9
10
40
Risk Analysis and Project Evaluation
2. International Cost of Capital
ICRG Financial as a Function of Sovereign Spread
Data through December 2005
50
y = -2.8186x + 52.639
R2 = 0.304
45
40
ICRG-F
35
30
25
20
15
10
5
0
0
1
2
3
4
5
6
Ln(Sovereign Spread)
7
8
9
10
41
Risk Analysis and Project Evaluation
2. International Cost of Capital
Goldman-Integrated-EHV Hybrid
• You just need a credit rating (available for 136
countries now) and the EHV model will deliver
the sovereign yield
42
Risk Analysis and Project Evaluation
2. International Cost of Capital
Goldman-Integrated-EHV Hybrid
• 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
43
Risk Analysis and Project Evaluation
2. International Cost of Capital
Goldman-Segmented
• Main problem is the beta
• It is too low for many risky markets
• Solution: Increase the beta
44
Risk Analysis and Project Evaluation
2. International Cost of Capital
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
45
Risk Analysis and Project Evaluation
2. International Cost of Capital
Goldman-Segmented
• Strange formulation. The usual beta is:
Betai ,World  Correlationi ,World 
Std.devi
Std.devWorld
• Using volatility ratio implies that the
Correlation=1 !!
46
Risk Analysis and Project Evaluation
2. International Cost of Capital
Goldman-Segmented
• No economic foundation for modification
• No clear economic foundation for method in
general
Recommendation: Not recommended
47
Risk Analysis and Project Evaluation
2. International Cost of Capital
CSFB
E[ri]=SYi + bi{E[rus-RFus] x Ai} x Ki
• SYi = brady yield (use fitted from EHV)
• bi = 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.
48
Risk Analysis and Project Evaluation
2. International Cost of Capital
CSFB
E[ri]=SYi + bi{E[rus-RFus] x Ai} x Ki
• Ai =the coefficient of variation (CV) in the local
market divided by the CV of the U.S. market)
where CV = s/mean.
• Ki =“constant term to adjust for the
interdependence between the risk-free rate and the
equity risk premium”
49
Risk Analysis and Project Evaluation
2. International Cost of Capital
CSFB
• No economic foundation
• Complicated, nonintuitive and ad hoc
Recommendation: Avoid
50
Risk Analysis and Project Evaluation
2. International Cost of Capital
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.
51
Risk Analysis and Project Evaluation
2. International Cost of Capital
Damodaran
Country
Sovereign
Equity std. dev.
equity = yield
x -----------------premium
spread
Bond std. dev.
52
Risk Analysis and Project Evaluation
2. International Cost of Capital
Damodaran
• Advantage: Recognizes that you just can’t
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.
53
Risk Analysis and Project Evaluation
3. Recommended Framework
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.
54
Risk Analysis and Project Evaluation
3. Recommended Framework
Country Risk Rating Model
• Erb, Harvey and Viskanta (1995)
• Explore risk surrogates:
–
–
–
–
Political Risk,
Economic Risk,
Financial Risk and
Country Credit Ratings
55
Risk Analysis and Project Evaluation
3. Recommended Framework
Country Risk Rating Model
Sources
•
•
•
•
•
Political Risk Services’ International Country Risk Guide
Institutional Investor’s Country Credit Rating
Euromoney’s Country Credit Rating
Moody’s
S&P
56
Risk Analysis and Project Evaluation
3. Recommended Framework
Political risk. International Country Risk Guide
Political
Economic expectations vs. reality
Economic planning failures
Political leadership
External conflict
Corruption in government
Military in politics
Organized religion in politics
Law and order tradition
Racial and nationality tensions
Political terrorism
Civil war
Political party development
Quality of the Bureaucracy
Total Political Points
Points
12
12
12
10
6
6
6
6
6
6
6
6
6
100
% of
Individual
% of
Index Composite
12%
6%
12%
6%
12%
6%
10%
5%
6%
3%
6%
3%
6%
3%
6%
3%
6%
3%
6%
3%
6%
3%
6%
3%
6%
3%
100%
50%
57
See appendix for more detail
Risk Analysis and Project Evaluation
3. Recommended Framework
Financial risk. International Country Risk Guide
Financial
Loan Default or unfavorable loan restructuring
Delayed payment of suppliers’ credits
Repudiation of contracts by governments
Losses from exchange controls
Expropriation of private investments
10
10
10
10
10
20%
20%
20%
20%
20%
5%
5%
5%
5%
5%
Total Financial Points
50
100%
25%
58
See appendix for more detail
Risk Analysis and Project Evaluation
3. Recommended Framework
Economic risk. International Country Risk Guide
Economic
Inflation
Debt service as a % of exports of goods and services
International liquidity ratios
Foreign trade collection experience
Current account balance as a % of goods and services
Parallel foreign exchange rate market indicators
10
10
5
5
15
5
20%
20%
10%
10%
30%
10%
5%
5%
3%
3%
8%
3%
Total Economic Points
50 100%
25%
Overall Points
200
100%
59
See appendix for more detail
Risk Analysis and Project Evaluation
3. Recommended Framework
International Country Risk Guide Risk Categories
Risk Category
Very High Risk
High Risk
Moderate Risk
Low Risk
Very Low Risk
Composite Score Range
0.0-49.5
50.0-59.5
60.0-69.5
70.0-84.5
85.0-100.0
60
See appendix for more detail
Risk Analysis and Project Evaluation
3. Recommended Framework
Institutional Investor’s Country Credit Ratings
Economic Outlook
Debt Service
Financial Reserves/Current
Account
Fiscal Policy
Political Outlook
Access to Capital Markets
Trade Balance
Inflow of Portfolio Investment
Foreign Direct Investment
OECD
1979
1994
1
1
5
2
2
3
9
3
6
4
7
8
4
5
6
7
8
9
Emerging
Rest of World
1979
1994
1979
1994
2
3
3
4
1
1
1
1
4
4
4
3
9
3
7
5
8
6
7
2
9
5
8
6
6
2
8
5
7
9
6
2
9
5
8
7
61
Risk Analysis and Project Evaluation
3. Recommended Framework
NR
B
B+
BB-
BB
BB+
BBB-
BBB
BBB+
A-
A
A+
AA-
AA
100
90
80
70
60
50
40
30
20
10
0
AA+
Institutional Investor CCR
Ratings are correlated:
S&P Sovereign Ratings
62
Risk Analysis and Project Evaluation
3. Recommended Framework
NR
B
B+
BB-
BB
BB+
BBB-
BBB
BBB+
A-
A
A+
AA-
AA
100
90
80
70
60
50
40
30
20
10
0
AA+
Euromoney CCR
Ratings are correlated:
S&P Sovereign Ratings
63
Risk Analysis and Project Evaluation
3. Recommended Framework
NR
B
B+
BB-
BB
BB+
BBB-
BBB
BBB+
A-
A
A+
AA-
AA
100
90
80
70
60
50
40
30
20
10
0
AA+
ICRG Composite
Ratings are correlated:
S&P Sovereign Ratings
64
Risk Analysis and Project Evaluation
3. Recommended Framework
Ratings are correlated:
II CCR
II CCR
ICRGC
ICRGP
ICRGF
ICRGE
ICRGC
-0.03
0.35
0.30
0.83
0.26
0.60
0.10
0.52
Risk Measure Levels
Risk Measure Changes
ICRGP ICRGF ICRGE
0.01
0.03
-0.09
0.79
0.54
0.43
0.25
0.06
0.35
0.05
0.24
0.25
65
Risk Analysis and Project Evaluation
3. Recommended Framework
ICRG ratings predict changes in II ratings:
Attribute Coefficient
ICRGC
0.2120
ICRGP
0.1244
ICRGF
0.0956
ICRGE
0.0833
T-Stat R-Square
7.59
5.0%
5.67
2.8%
5.69
2.8%
4.65
1.9%
66
Risk Analysis and Project Evaluation
3. Recommended Framework
Inflation expectations for 1997
Ratings predict inflation:
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0
20
40
60
II Rating September 1996
80
100
67
Risk Analysis and Project Evaluation
3. Recommended Framework
Ratings correlated with wealth:
Per capita real GDP
$25,000
$20,000
$15,000
$10,000
$5,000
$0
0
20
40
60
II ratings for 74 countries
80
100
68
Risk Analysis and Project Evaluation
3. Recommended Framework
Time-series of ratings:
19
7
19 9
8
19 0
8
19 1
8
19 2
8
19 3
8
19 4
8
19 5
8
19 6
8
19 7
8
19 8
8
19 9
9
19 0
9
19 1
9
19 2
9
19 3
9
19 4
9
19 5
9
19 6
9
19 7
98
100
90
80
70
60
50
40
30
20
10
0
Switzerland
Italy
Kuwait
Argentina
69
Risk Analysis and Project Evaluation
3. Recommended Framework
Returns and Institutional Investor Country Credit
Ratings from 1990
Average returns
0.5
0.4
R2 = 0.2976
0.3
0.2
0.1
0.0
-0.1
0
20
40
60
80
100
Rating
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.
70
Risk Analysis and Project Evaluation
3. Recommended Framework
Credit Rating Model
• Intuitive
• Can be used in 136 countries, that is, in countries
without equity markets
• Fits developed and emerging markets
71
Risk Analysis and Project Evaluation
3. Recommended Framework
Country Risk Rating Model
STEPS:
EVR = risk free + intercept - slope x Log(IICCR)
• Where Log(IICCR) is the natural logarithm of the
Institutional Investor Country Credit Rating
72
Risk Analysis and Project Evaluation
3. Recommended Framework
Easy to use:
70%
50%
40%
30%
20%
10%
100
90
80
70
60
50
40
30
20
10
0%
0
Hurdle rate
60%
Rating
ICRGC
IICCR:84
IICCR:79
73
Risk Analysis and Project Evaluation
3. Recommended Framework
Also predicts volatility:
70%
Annualized Volatility
60%
2
R = 0.5033
50%
40%
30%
20%
10%
0%
0
20
40
60
80
100
Institutional Investor Country Credit Rating
74
Risk Analysis and Project Evaluation
3. Recommended Framework
0
10
90
80
70
60
50
40
30
20
10
80%
70%
60%
50%
40%
30%
20%
10%
0%
0
Expected volatility
Fitted volatility:
Rating
IICCR:84
IICCR:79
75
Risk Analysis and Project Evaluation
3. Recommended Framework
And correlation.
100%
2
R = 0.6809
Correlation with MSCI AC World
80%
60%
40%
20%
0%
0
20
40
60
80
100
-20%
Institutional Investor Countyr Credit Rating
76
Risk Analysis and Project Evaluation
3. Recommended Framework
80%
60%
40%
0
10
-40%
90
80
70
60
50
40
30
20
0%
-20%
10
20%
0
Expected correlation with world
Fitted correlation.
-60%
-80%
-100%
Rating
IICCR:84
IICCR:79
77
Risk Analysis and Project Evaluation
3. Recommended Framework
ICRG rating
Asian Crisis.
100
90
80
70
60
50
40
30
20
10
0
7
-9
n
Ja
7
-9
ar
M
7
-9
y
a
M
China
Korea
Singapore
7
l-9
Ju
pSe
97
N
7
-9
v
o
Hong Kong
Malaysia
Taiwan
8
8
98
-9
-9
r
n
y
a
a
Ja
M
M
India
Pakistan
Thailand
8
l-9
Ju
Indonesia
Philippines
Russia
78
Risk Analysis and Project Evaluation
3. Recommended Framework
Asian Crisis.
Beginning of
crisis
90
ICRG rating
85
80
75
70
65
60
9
nJa
7
7
-9
ar
M
7
-9
y
a
M
7
7
7
-9
-9
l-9
v
p
u
o
J
Se
N
Korea
8
-9
n
Ja
Malaysia
8
8
-9
-9
y
ar
a
M
M
Russia
8
l-9
Ju
pSe
98
79
Risk Analysis and Project Evaluation
3. Recommended Framework
Value of $100
Value of US$100
Beginning of
crisis
200
180
160
140
120
100
80
60
40
20
0
9
nJa
7
7
-9
ar
M
7
-9
ay
M
7
7
7
-9
-9
l-9
v
p
u
e
o
J
S
N
Korea
8
8
98
-9
r-9
ny
a
a
a
J
M
M
Malaysia
Russia
8
l-9
Ju
pSe
98
80
Risk Analysis and Project Evaluation
3. Recommended Framework
Value of local currency
(indexed at 100)
Beginning of
crisis
120
Value of $100
100
80
60
40
20
0
9
nJa
7
7
-9
ar
M
7
-9
y
a
M
7
7
7
-9
-9
l-9
v
p
u
o
J
Se
N
Korea
8
-9
n
Ja
Malaysia
8
8
-9
-9
y
ar
a
M
M
Russia
8
l-9
Ju
pSe
98
81
Ja
n
Fe -01
M b-01
a
A r-0
p 1
M r-0
ay 1
Ju -01
n
Ju -01
A l -0
ug 1
Se -01
O p-01
c
N t-01
o
D v-0
ec 1
Ja -01
n
Fe -02
M b-02
a
A r-0
p 2
M r-0
ay 2
Ju -02
n
Ju -02
A l -0
ug 2
Se -02
O p-02
c
N t-02
o
D v-0
ec 2
Ja -02
n
Fe -03
M b-03
a
A r-0
p 3
M r-0
ay 3
Ju -03
n03
Risk Analysis and Project Evaluation
100
3. Recommended Framework
95
90
85
80
75
70
65
60
Equally-weighted world
G-7xUS
Switzerland
United States
82
Ja
n
Fe -01
M b-01
a
A r-0
p 1
M r-0
ay 1
Ju -01
n
Ju -01
A l -0
ug 1
Se -01
O p-01
c
N t-01
o
D v-0
ec 1
Ja -01
n
Fe -02
M b-02
a
A r-0
p 2
M r-0
ay 2
Ju -02
n
Ju -02
A l -0
ug 2
Se -02
O p-02
c
N t-02
o
D v-0
ec 2
Ja -02
n
Fe -03
M b-03
a
A r-0
p 3
M r-0
ay 3
Ju -03
n03
ICRG
Political Risk
100
Risk Analysis and Project Evaluation
3. Recommended Framework
95
90
85
80
75
70
65
60
Equally-weighted world
Japan
Switzerland
United States
83
Ja
n
Fe -01
M b-01
a
A r-01
M pr-0
ay 1
Ju -01
n
Ju -01
A l -0
u 1
Se g-01
p
O -01
c
N t-01
o
D v-0
ec 1
Ja -01
n
Fe -02
M b-02
a
A r-0
p 2
M r-0
ay 2
Ju -02
nJu 02
A l -0
ug 2
Se -02
p
O -02
c
N t-02
o
D v-0
ec 2
Ja -02
n
Fe -03
M b-0
a 3
A r-03
p
M r-0
ay 3
Ju -03
n03
ICRG
Political Risk
100
95
90
85
80
75
70
65
60
Risk Analysis and Project Evaluation
3. Recommended Framework
Equally-weighted world
Germany
United States
Japan
Switzerland
84
Risk Analysis and Project Evaluation
4. Comparison of Methods
35.00%
68%
30.00%
25.00%
CAPM
Ibbotson
EHV
GS-EHV
GS-Seg
CSFB-EHV
20.00%
15.00%
10.00%
5.00%
0.00%
Argentina
Mexico
Thailand
85
Risk Analysis and Project Evaluation
4. Comparison of Methods
537%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
-20.00%
CAPM
Ibbotson
EHV
GS-EHV
GS-Seg
CSFB-EHV
Slovakia
Pakistan
United States
86
Risk Analysis and Project Evaluation
Excel version
4. Comparison of Methods
87
Risk Analysis and Project Evaluation
5. Conversion of Cash Flows
Forward Rate
• Intuitive (expected exchange rate levels)
• Works fine for developed countries
• In emerging markets, there are two problems
– Data not readily available
– May reflect a risk premium (for default)
88
Risk Analysis and Project Evaluation
5. Conversion of Cash Flows
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)
89
Risk Analysis and Project Evaluation
5. Conversion of Cash Flows
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)
90
Risk Analysis and Project Evaluation
5. Conversion of Cash Flows
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
91
flows
Risk Analysis and Project Evaluation
5. Conversion of Cash Flows
Robustness
• In some countries, it is difficult to get a good
inflation forecast.
• An alternative is the following:
– Subtract the sovereign spread from a local interest rate
of the same duration
– Calculate a risk-adjusted forward rate
– Convert cash flows to USD using the risk-adjusted
forward rate
– Discount with the ICCRC
92
Risk Analysis and Project Evaluation
6. Industry Adjustments
Industry Risk
• ICCRC delivers a risk adjustment that reflects the
weighted average risk of all industries within a
country
• For most emerging markets, the country risk
component dominates differences due to
industries.
93
Risk Analysis and Project Evaluation
6. Industry Adjustments
Industry Risk
• Industry adjustment:
– Calculate the country risk premium from ICCRC
(Country cost of equity capital – U.S. cost of capital)
– Using the industry beta, determine the U.S. industry
cost of capital [=risk free + beta(U.S. risk premium)]
– Add the country risk premium to the U.S. industry cost
of capital
94
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
Project Risk Analysis
• Operating Risk
– Pre-completion
– Post-completion
– Sovereign
• Financial Risk
95
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
Operating Risk
• Pre-completion
–
–
–
–
Resources available (quality/quantity)
Technological risk (proven technology?)
Timing risks (failure to meet milestones)
Completion risk
Handle in cash flows and/or industry
adjustment.
96
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
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 and/or industry
adjustment.
97
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
Operating Risk
• Sovereign Risk (Macroeconomic)
– Exchange rate changes
– Currency convertibility and transferability
– Hyperinflation risk
Handle through discount rate. Inflation rate
should be handled in the forecasted
exchange rates used to put cash flows in
USD
98
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
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
Handle through discount rate
99
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
Operating Risk
• Sovereign Risk (Force Majeure)
– Political events
•
•
•
•
Wars
Labor strikes
Terrorism
Changes in laws
– Natural catastrophes
• Hurricanes/earthquakes/floods
Handle through discount rate
100
Risk Analysis and Project Evaluation
7. Project Specific Adjustments
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
Handle through discount rate
101
Risk Analysis and Project Evaluation
8. Risk Worksheet
Cost of Capital Worksheet
Worksheet calculates cost of equity capital in nominal U.S. dollar terms.
Convert local currency cash flows to USD by the assumption of Purchasing Power Parity, i.e. the expected
annual depreciation in the FX rate is exactly equal to the difference between local and U.S. inflation rates.
Risk Premium Calculation
Inputs
Output Category
5.02
U.S. risk free in %
3.30
U.S. risk premium in %
91.60
Current U.S. Credit Rating
38.98
Institutional Investor country credit rating (0-100)
23.44 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)
15.12 Country Risk Premium
Industry Adjustment
0.80
Beta (Industry)
-0.66 Sector adjustment
102
Risk Analysis and Project Evaluation
8. Risk Worksheet
Project Risk Mitigation
(-10 to 10; where 10=risk completely eliminated, 0=average for country)
Impact on
Country
Premium
Weights Score
Sovereign
0.40
10.00
-6.05 Currency (direct, e.g. convertibility)
0.10
10.00
-1.51 Currency (indirect, e.g. political risk caused by crisis)
0.15
-2.00
0.45 Expropriation (direct, diversion, creeping)
0.05
3.00
-0.23 Commercial International partners
0.05
5.00
-0.38 Involvement of Multilateral Agencies
0.05
0.00
0.00 Sensitivity of Project to wars, strikes, terrorism
0.05
0.00
0.00 Sensitivity of Project to natural disasters
0.05
0.03
0.05
0.03
0.00
0.00
2.00
2.00
Operating
0.00 Resource risk
0.00 Technology risk
Financial
-0.15 Probability of Default
-0.08 Political Risk Insurance
1.00
Project Cost of Capital
Sum of weights (make sure = 1.00)
14.84
103
Risk Analysis and Project Evaluation
Cash Flow Check List:
8. Risk Worksheet
Operating-Precompletion
Resources available (quantity/quality) -part not in discount rate
Technology (proven technology) -part not in discount rate
Timing risks (penalties for milestones)
Operating-Post-completion
Market risks (prices of outputs)
Supply/input risk (availability)
Throughput risk (material put through plus efficiency of systems operation)
Operating costs
Sovereign
Inflation assumptions/Exchange rates
Real Options
Input mix or process flexibility
Output mix or product flexibility
Abandonment or termination
Temporary stop or shutdown
Intensity or operating scale
Expansion
Contraction
Initiation or deferment
Interproject/intraproject
Growth
Shadow costs
Financial flexibility
104
Complex options which might diminish or augment value of other options
Risk Analysis and Project Evaluation
9. Conclusions
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.
105
Risk Analysis and Project Evaluation: Risk Ratings Appendix
Political risk rating
The value of the the Political Risk Service (PRS) Group’s political risk indicator (which ranges between 0
and 100). The risk rating is a combination of 12 subcomponents (documented below). Overall, a political
risk rating of 0.0% to 49.9% indicates a Very High Risk; 50.0% to 59.9% High Risk; 60.0% to 69.9%
Moderate Risk; 70.0% to 79.9% Low Risk; and 80.0% or more Very Low Risk. The data are available for
samples II, III and IV from 1984 through 1997. For each country, we backfill the 1984 value to 1980.
Source: Various issues of the International Country Risk Guide.
Government stability
ICRG political risk sub-component (12% weight). This is a measure both of the government’s ability to
carry out its declared program(s), and its ability to stay in office. This will depend on the type of
governance, the cohesion of the government and governing party or parties, the closeness of the next
election, the government’s command of the legislature, and popular approval of government policies.
Socioeconomic Conditions
ICRG political risk sub-component (12% weight). This is an attempt to measure general public satisfaction,
or dissatisfaction, with the government’s economic policies. In general terms, the greater the popular
dissatisfaction with a government’s policies, the greater the chances that the government will be forced to
change direction, possibly to the detriment of business, or will fall. Socioeconomic conditions cover a
broad spectrum of factors ranging from infant mortality and medical provision to housing and interest rates.
Within this range different factors will have different weight in different societies. PRS attempts to identify
those factors that are important for the society in question, i.e. those with the greatest political impact, and
assess the country on that basis.
Investment Profile
ICRG political risk sub-component (12% weight). This is a measure of the government’s attitude to inward
investment. The investment profile is determined by PRS's assessment of four sub-components: (i) risk of
expropriation or contract viability (scored from zero [very high risk] to four [very low]); (ii) taxation
(scored from zero to three, corresponding to very high, high, medium, and low risk; (iii) repatriation
(scored from zero to three); and (iv) and labor costs (scored from zero to two, corresponding to high,
medium and low).
Internal Conflict
ICRG political risk sub-component (12% weight). This is an assessment of political violence in the country
and its actual or potential impact on governance. The highest rating is given to those countries where there
is no armed opposition to the government and the government does not indulge in arbitrary violence, direct
or indirect, against its own people. The lowest rating is given to a country embroiled in an on-going civil
war. The intermediate ratings are awarded on the basis of whether the threat posed is to government and
business or only business (e.g. kidnapping for ransom); whether acts of violence are carried out for a
political objective (i.e. terrorist operations); whether such groups are composed of a few individuals with
little support, or are well-organized movements operating with the tacit support of the people they purport
to represent; whether acts of violence are sporadic or sustained; and whether they are restricted to a 106
particular locality or region, or are carried out nationwide.
Risk Analysis and Project Evaluation: Risk Ratings Appendix
External Conflict
ICRG political risk sub-component (12% weight). The external conflict measure is an assessment of the risk
to both the incumbent government and inward investment. It ranges from trade restrictions and embargoes,
whether imposed by a single country, a group of countries, or the whole international community, through
geopolitical disputes, armed threats, exchanges of fire on borders, border incursions, foreign-supported
insurgency, and full-scale warfare.
Corruption
ICRG political risk sub-component (6% weight). This is a measure of corruption within the political
system. Such corruption: distorts the economic and financial environment, reduces the efficiency of
government and business by enabling people to assume positions of power through patronage rather than
ability, and introduces an inherent instability into the political process. The most common form of
corruption met directly by business is financial corruption in the form of demands for special payments and
bribes connected with import and export licenses, exchange controls, tax assessments, police protection, or
loans. Although the PRS measure takes such corruption into account, it is more concerned with actual or
potential corruption in the form of excessive patronage, nepotism, job reservations, “favor-for-favors,”
secret party funding, and suspiciously close ties between politics and business. In PRS's view these sorts of
corruption pose risk to foreign business, potentially leading to popular discontent, unrealistic and inefficient
controls on the state economy, and encourage the development of the black market.
Military in Politics
ICRG political risk sub-component (6% weight). The military is not elected by anyone. Therefore, its
involvement in politics, even at a peripheral level, is a diminution of democratic accountability. However,
it also has other significant implications. The military might, for example, become involved in government
because of an actual or created internal or external threat. Such a situation would imply the distortion of
government policy in order to meet this threat, for example by increasing the defense budget at the expense
of other budget allocations. In some countries, the threat of military take-over can force an elected
government to change policy or cause its replacement by another government more amenable to the
military’s wishes. A military takeover or threat of a takeover may also represent a high risk if it is an
indication that the government is unable to function effectively and that the country therefore has an uneasy
environment for foreign businesses. A full-scale military regime poses the greatest risk.
Religion in Politics
ICRG political risk sub-component (6% weight). Religious tensions may stem from the domination of
society and/or governance by a single religious group that seeks to replace civil law by religious law and to
exclude other religions from the political and/or social process; the desire of a single religious group to
dominate governance; the suppression of religious freedom; the desire of a religious group to express its
own identity, separate from the country as a whole. The risk involved in these situations range from 107
inexperienced people imposing inappropriate policies through civil dissent to civil war.
Risk Analysis and Project Evaluation: Risk Ratings Appendix
Law and Order
ICRG political risk sub-component (6% weight). PRS assesses Law and Order separately, with each subcomponent comprising zero to three points. The Law sub-component is an assessment of the strength and
impartiality of the legal system, while the Order sub-component is an assessment of popular observance of
the law. Thus, a country can enjoy a high rating (3.0) in terms of its judicial system, but a low rating (1.0)
if the law is ignored for a political aim.
Ethnic Tensions
ICRG political risk sub-component (6% weight). This component measures the degree of tension within a
country attributable to racial, nationality, or language divisions. Lower ratings are given to countries where
racial and nationality tensions are high because opposing groups are intolerant and unwilling to
compromise. Higher ratings are given to countries where tensions are minimal, even though such
differences may still exist.
Democratic Accountability
ICRG political risk sub-component (6% weight). This is a measure of how responsive government is to its
people, on the basis that the less responsive it is, the more likely it is that the government will fall,
peacefully in a democratic society, but possibly violently in a non-democratic one. However, assessing
democratic accountability is more complex than simply determining whether the country has free and fair
elections. Even democratically elected governments, particularly those that are apparently popular, can
delude themselves into thinking they know what is good for their people even when the people have made it
abundantly clear that they do not approve particular policies. Therefore, it is possible for an accountable
democracy to have a lower score, i.e. a higher risk, for this component than a less democratic form of
government.
Bureaucratic Quality
ICRG political risk sub-component (4% weight). The institutional strength and quality of the bureaucracy is
tends to minimize revisions of policy when governments change. Therefore, high points are given to
countries where the bureaucracy has the strength and expertise to govern without drastic changes in policy
or interruptions in government services. In these low-risk countries, the bureaucracy tends to be somewhat
autonomous from political pressure and to have an established mechanism for recruitment and training.
Countries that lack the cushioning effect of a strong bureaucracy receive low points because a change in
government tends to be traumatic in terms of policy formulation and day-to-day administrative functions.
108
Risk Analysis and Project Evaluation: Risk Ratings Appendix
Financial risk rating
The value of the the Political Risk Service (PRS) Group’s financial risk indicator (which ranges between 0
and 100). The risk rating is a combination of 5 subcomponents (documented below). PRS assigns risk
points to a pre-set group of factors, termed financial risk components. The minimum number of points for
each component is zero, while the maximum number of points depends on the fixed weight that component
is given in the overall financial risk assessment. Overall, a financial risk rating of 0.0% to 24.5% indicated
a Very High Risk; 25.0% to 29.9% High Risk; 30.0% to 34.9% Moderate Risk; 35.0% to 39.9% Low Risk;
and 40.0% or more Very Low Risk.
Foreign debt as a % of GDP
ICRG financial risk sub-component (20% weight). The estimated gross foreign debt in a given year,
converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the
gross domestic product converted into US dollars at the average exchange rate for that year. If the ratio is 05%, then the highest rating of 10/10 is assigned. The rating decreases by 0.5 for every 5% increment until a
ratio of 50%. After 50%, the rating decreases by 0.5 for every increment of 10% until a ratio of 130%. A
rating of 0.5 is assigned for ratios between 150-200% and zero is assigned for higher ratios.
Foreign debt service as a % of exports of goods and
services
ICRG financial risk sub-component (20% weight). The estimated foreign debt service, for a given year,
converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the sum
of the estimated total exports of goods and services for that year, converted into US dollars at the average
exchange rate for that year. If the ratio is between 0 and 4.9%, the highest rating of 10/10 is applied. The
rating decreases by 0.5 for every 4% increase in the ratio. At a ratio of 85% and above, the rating is zero.
Current account as a % of exports of goods and
services
ICRG financial risk sub-component (30% weight). The estimated foreign debt service, for a given year,
converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the sum
of the estimated total exports of goods and ser-vices for that year, converted into US dollars at the average
exchange rate for that year. The highest rating of 10/10 is given to current account ratios of 25% and over.
The rating decreases by 0.5 for every 5% decrease in the ratio. If the ratio is -120% or below, the rating is
zero.
109
Risk Analysis and Project Evaluation: Risk Ratings Appendix
Net international liquidity as months of import cover ICRG financial risk sub-component (10% weight). The total estimated official reserves for a given year,
converted into US dollars at the average exchange rate for that year, including official holdings of gold
converted into US dollars at the free market price for the period, but excluding the use of IMF credits and
the foreign liabilities of the monetary authorities, is divided by the average monthly merchandise import
cost, converted into US dollars at the average exchange rate for the period. This provides a comparative
liquidity risk ratio that indicates how many months of imports can be financed with reserves. The maximum
rating of 5/5 is given to countries with a ratio of 15 or over. The rating decreases by 0.5 points for
decreases in the ratio of 3.0 until a ratio of 5.0 it hit. The points then drop by 0.5 for every decrease of 1.0
in the ratio. 0.5 points are assigned for ratios between 0.6 and 1 and zero points if the ratio is below.
Exchange rate stability
ICRG financial risk sub-component (20% weight). The appreciation or depreciation of a currency against
the US dollar (against the German mark or Euro in the case of the US) over a calendar year or the most
recent 12-month period is calculated as a percentage change. For appreciations, the maximum of 10/10 is
assigned for 0 to 9.9% appreciations. The rating decreases by 0.5 for incremental 5% appreciations. For
appreciations of 20% to 30%, the rating decreases by 0.5 for 2.5% increments. For appreications between
30 and 40%, the rating decreases by 0.5 for 5% increments. For appreciations between 40-49.9%, 5.5 rating
points are assigned. Appreciations of 50% and above are assigned 5 points. For depreciations, 0.1-4.9 are
assigned the maximum 10/10. For 2.5% increments in depreciation, 0.5 are deducted from the rating until
30% is hit. From 30-59.9%, 0.5 is deducted for 5% increments. From 60 to 99.9%, ratings decrease by 0.5
for 10% increments. For 100% or greater depreciations, zero points are assigned.
110
Risk Analysis and Project Evaluation: Risk Ratings Appendix
Economic risk rating
The value of the the Political Risk Service (PRS) Group’s economic risk indicator (which ranges between 0
and 100). The risk rating is a combination of 5 subcomponents (documented below). PRS assigns risk
points to a pre-set group of factors, termed financial risk components. The minimum number of points for
each component is zero, while the maximum number of points depends on the fixed weight that component
is given in the overall financial risk assessment. Overall, a financial risk rating of 0.0% to 24.5% indicated
a Very High Risk; 25.0% to 29.9% High Risk; 30.0% to 34.9% Moderate Risk; 35.0% to 39.9% Low Risk;
and 40.0% or more Very Low Risk.
GDP Per Head
ICRG economic risk sub-component (10% weight). The estimated GDP per head for a given year,
converted into US dollars at the average exchange rate for that year, is expressed as a percentage of the
average of the estimated total GDP of all the countries covered by ICRG. Measures of 250% or greater get
the maximum weight of 5/5. The rating decreases by 0.5, in 50% increments until a percentage of 100% is
attained. The rating decreases by 0.5 in 25% increments until the percentage of the average GDP is 50%.
The rating then decreases by 0.5 in 10% increments. For countries with less then 10% of the average GDP,
a rating of zero is assigned.
Real GDP Growth
ICRG economic risk sub-component (20% weight). The annual change in the estimated GDP, at constant
1990 prices, of a given country is expressed as a percentage increase or decrease. The maximum rating of
10/10 is assigned to countries with 6% and higher growth. The ratings decrease by 0.5 for every 1%
decrease in growth until 3%. The ratings then decrease by 0.5 for 0.5% decreases in real growth. If growth
is -6% or less, the rating is zero.
Annual Inflation Rate
ICRG economic risk sub-component (20% weight). The estimated annual inflation rate (the unweighted
average of the Consumer Price Index (calculated as a percentage change. If inflation is less than 2%, the
maximum 10/10 points are assigned. The points are decreased by 0.5 for every 1% increase in the inflation
rate up to 10%. The rating decreases by 0.5 points for inflation rates between 10 and 15.9% in 2%
increments, between 16 and 24.9% in 3% increments, 25 and 30.9% in 6% increments, 31 and 50.9% in
10% increments, 66 and 129.9 in 20% increments. A rating of zero is assigned to countries with inflation
rates of 130% and greater.
111
Risk Analysis and Project Evaluation: Risk Ratings Appendix
Budget Balance as a Percentage of GDP
ICRG economic risk sub-component (20% weight). The estimated general government budget balance
(excluding grants) for a given year in the national currency is expressed as a percentage of the estimated
GDP for that year in the national currency. The maximum rating of 10/10 is assigned to countries with 4%
or greater surpluses. The rating decreases by 0.5 points for budget balances between 6 and -9.9% in 1%
increments, between 10 and 11.9% in 2% increments, 12 and 14.9% in 3% increments, 15 and 29.9% in 5%
increments. A rating of zero is assigned to countries with budget deficit that are 30% and greater.
Current Account as a Percentage of GDP
ICRG economic risk sub-component (30% weight). The estimated balance on the current account of the
balance of payments for a given year, converted into US dollars at the average exchange rate for that year,
is expressed as a percentage of the estimated GDP of the country concerned, converted into US dollars at
the average rate of exchange for the period covered. The maximum rating of 15/15 is assigned to countries
with surpluses that are 10% and greater. The rating decreases by 0.5 points for current account balance
percentages between 10 and 2% in 2% increments, between 1.9 and -0.9% in 1% increments, -1 and 15.9% in 2% increments, -16 and -24.9% in 1% increments, betweenb -25 and -29.9% in 2% increments, 30 to 3-34.9% in 2.5% increments, and -35 to -39.9% in 5% increments. A rating of zero is assigned to
countries with current account percentages that that are -40% or less.
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Risk Analysis and Project Evaluation: U.S. Risk Premium
•10-year risk premium is stable. Currently, about 2.5%
6
5
4
3
2
1
0
6-Jun-00
10-Sep-01
2-Dec-02
10-Mar-04
31-May-05
7-Sep-00
4-Dec-01
19-Mar-03
10-Jun-04
29-Aug-05
4-Dec-00
11-Mar-02
16-Jun-03
10-Sep-04
21-Nov-05
12-Mar-01
4-Jun-02
18-Sep-03
10-Dec-04
6-Mar-06
7-Jun-01
16-Sep-02
10-Dec-03
10-Mar-05
Source: Graham and Harvey (2006)
113
Risk Analysis and Project Evaluation: The Author
Campbell R. Harvey is the J. Paul Sticht Professor of International Business at the Fuqua School of Business, Duke
University. He is also a Research Associate of the National Bureau of Economic Research in Cambridge, Massachusetts.
Professor Harvey obtained his doctorate at the University of Chicago in business finance. His undergraduate studies in
economics were conducted at the University of Toronto. He has served on the faculties of the Stockholm School of Economics, the
Helsinki School of Economics, and the Graduate School of Business at the University of Chicago. He has also been a visiting scholar at
the Board of Governors of the Federal Reserve System. He was recently awarded an honorary doctorate from Svenska
Handelshögskolan in Helsinki.
Harvey is an internationally recognized expert in portfolio management and global risk management. His work on the
implications of changing risk and the dynamics of risk premiums for tactical asset allocation has been published in the top academic and
practitioner journals. He has published over 100 scholarly articles and books. His work is frequently presented in international
conferences and is often featured in the business press.
In addition, Professor Harvey has wide-ranging practical experience. He serves as a consultant to some of the world's
leading asset management and consulting firms. Harvey specializes in the construction of global equity and fixed income allocation
models as well as providing estimates of the international cost of capital.
Harvey is Editor-Elect of the Journal of Finance which is the leading scientific publication in the field of finance and the
second highest rated journal in the economics profession. He is a former Editor of the Review of Financial Studies another leading
publication in finance. In addition, he is an Associate Editor of the Journal of Financial Economics, the Financial Analysts Journal, the
Journal of Empirical Finance, the Journal of Fixed Income, the Pacific Basin Finance Journal, the Journal of International Financial
Institutions, Markets and Money, European Financial Management, the International Review of Economics and Finance, and the
European Journal of Finance. He is also Co-Editor of the Emerging Markets Review.
Harvey received the 1993-94 Batterymarch Fellowship. This annual award is given to the person that is most likely to
establish a new area of research in finance. Harvey has been awarded four Graham and Dodd Scrolls for excellence in financial writing
from the Association for Investment Management and Research. The American Finance Association awarded Harvey a Smith-Breeden
prize for his publication "The World Price of Covariance Risk" and he has received the American Association of Individual Investors'
Best Paper in Investments Award for "Predictable Risk and Returns in Emerging Markets." His paper on the "Dynamics of Capital
Flows" recently received the New York Stock Exchange's Best Paper in Equities Award in 2000. Harvey is past winner of the
Outstanding Faculty Award at the Fuqua School of Business, an annual award given by the students. He was named by Business Week
as one of Duke's outstanding teachers.
Harvey is also active on the Internet. He successfully conducted a live Webcast of his Global Asset Allocation and Stock
Selection course. The students participating in the Webcast were from firms that, in aggregate, manage $1.6 trillion. His hypertextual
financial glossary is used by The New York Times, Forbes, Bloomberg, The Washington Post, CNN-Money, and Yahoo to name a few
of the sites. The glossary, which is the most comprehensive in the world, contains over 8,000 terms and over 18,000 links. He recently
published a book with 2002 Pulitzer Prize winner Gretchen Morgenson, The New York Times Dictionary of Money and Investing.
114