Risk Analysis and Project Evaluation Campbell R. Harvey Duke University and National Bureau of Economic Research May 2005.

Risk Analysis and Risk Analysis and Project EvaluationProject Evaluation

Campbell R. HarveyDuke University

andNational Bureau of Economic Research

May 2005

2

1. Cash Flow versus Discount Rate2. Approaches to Cost of Capital Measurement3. Recommended Framework4. Comparison of Methods5. Conversion of Cash Flows 6. Industry Adjustments7. Project Specific Adjustments8. Risk Worksheet9. Conclusions10. Appendices

Risk Analysis and Project EvaluationRisk Analysis and Project EvaluationPlan

3

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

Risk Analysis and Project EvaluationRisk Analysis and Project Evaluation1. Cash Flow vs. Discount Rate

4

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


5

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


6

Simple example:• If we reflect the country risk in the cash

flows, the value is identical Value = $50/0.10 = $500


7

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.


8

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.


9

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)

Risk Analysis and Project EvaluationRisk Analysis and Project Evaluation2. International Cost of Capital

10

Risk Analysis and Project EvaluationRisk 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

11

Identical Cost of Capital

• Ignores the fact that shareholders require different expected returns for different risks


12

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 valueAvoid


13

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

Risk Analysis and Project Evaluation Risk Analysis and Project Evaluation 2. International Cost of Capital

14

World CAPM• Expected discount rate (in U.S. dollars) on

investment that has average in a country = riskfree + 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)


15

World CAPM

• Strong assumptions needed• Perfect market integration• Mean-variance analysis implied by utility

assumptions• Fails in emerging markets


16

Returns and Beta from 1970

R2 = 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

Ave

rage

ret

urns

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


17

Returns and Beta from 1990

R2 = 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

Ave

rage

ret

urns

Still goes the wrong way - even with data from 1990!


18

World CAPM

• OK to use in developed markets• May give unreliable results in smaller, less liquid

developed markets


19

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


20


• 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


21


Estimate world beta and expected return

= riskfree + w x world risk premium

Estimate local beta and expected return

= local riskfree + L x local risk premium


22


• 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


23


• 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


24

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.


25

Ibbotson Associates• STEPS1 Calculate world risk premium=U.S. risk premium

divided by the beta versus the MSCI world 2 Estimate country beta versus world index3 Multiply this beta times world risk premium


26

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.”


27

Ibbotson Associates

• Gives unreasonable results in some countries• Only useful if equity markets exist• Ibbotson Associates does not even use itRecommendation: Do not use this version.

Ibbotson has alternative methods available.


28

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”


29

CAPM with Skewness

• But this is just preference for positive skewness (big positive outcomes)

• People like positive skewness and dislike negative skewness (downside)


30

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


31

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


32

CAPM with Skewness

• Model still being developed• Skewness similar to many “real options” that are

important in project evaluationRecommendation: Wait


33

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 capitalasset pricing model to emerging markets, Goldman Sachs, June 18, 1993.

34

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”


35

Goldman-Integrated

STEPS• Estimate market beta on the S&P 500• Beta times historical US premium • Add sovereign yield spread plus the risk free


36

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


37

Real Yields and Institutional Investor Country Credit Ratings from 1990 through 1998:03

R2 = 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

Rea

l Yie

lds


38


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


39


• 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


40

Goldman-Segmented

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


41

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


42

Goldman-Segmented

• Strange formulation. The usual beta is:

• Using volatility ratio implies that the Correlation=1 !!

World

iWorldiWorldi devStd

devStdnCorrelatioBeta

.

.,,


43

Goldman-Segmented

• No economic foundation for modification• No clear economic foundation for method in

generalRecommendation: Not recommended


44

CSFB

E[ri]=SYi + i{E[rus-RFus] x Ai} x Ki

• SYi = brady yield (use fitted from EHV)

• 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.

45

CSFB

E[ri]=SYi + i{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 = /mean.

• Ki =“constant term to adjust for the interdependence between the risk-free rate and the equity risk premium”


46

CSFB

• No economic foundation• Complicated, nonintuitive and ad hocRecommendation: Avoid


47

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.

48

Damodaran

Country Sovereign Equity std. dev. equity = yield x ------------------premium spread Bond std. dev.


49

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.


50

Country Risk Rating Model

• Erb, Harvey and Viskanta (1995)• Credit rating a good ex ante measure of risk• Impressive fit to data

Risk Analysis and Project Evaluation Risk Analysis and Project Evaluation 3. Recommended Framework

C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Journal of Portfolio Management, 1995.

51


• Erb, Harvey and Viskanta (1995)• Explore risk surrogates:

– Political Risk,

– Economic Risk,

– Financial Risk and

– Country Credit Ratings


52


Sources• Political Risk Services’ International Country Risk Guide

• Institutional Investor’s Country Credit Rating

• Euromoney’s Country Credit Rating

• Moody’s

• S&P


53

Political risk. International Country Risk Guide% of

Individual % ofPolitical Points Index CompositeEconomic 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%


See appendix for more detail

54

Financial risk. International Country Risk Guide

FinancialLoan 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%



55

Economic risk. International Country Risk Guide

EconomicInflation 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%



56

International Country Risk Guide Risk Categories

Risk Category Composite Score Range

Very High Risk 0.0-49.5

High Risk 50.0-59.5Moderate Risk 60.0-69.5

Low Risk 70.0-84.5

Very Low Risk 85.0-100.0



57

Institutional Investor’s Country Credit Ratings

OECD Emerging Rest of World1979 1994 1979 1994 1979 1994

Economic Outlook 1 1 2 3 3 4Debt Service 5 2 1 1 1 1Financial Reserves/CurrentAccount

2 3 4 4 4 3

Fiscal Policy 9 4 9 7 6 6Political Outlook 3 5 3 2 2 2Access to Capital Markets 6 6 7 9 8 9Trade Balance 4 7 5 5 5 5Inflow of Portfolio Investment 7 8 8 8 7 8Foreign Direct Investment 8 9 6 6 9 7


58

Ratings are correlated:

0102030405060708090

100

Inst

itut

iona

l Inv

esto

r C

CR

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B

NR

S&P Sovereign Ratings


59


0102030405060708090

100

Eur

omon

ey C

CR

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B

NR



60


0102030405060708090

100

ICR

G C

ompo

site

AA

+

AA

AA

-

A+ A A-

BB

B+

BB

B

BB

B-

BB

+

BB

BB

-

B+ B

NR



61


Risk Measure ChangesII CCR ICRGC ICRGP ICRGF ICRGE

II CCR -0.03 0.01 0.03 -0.09ICRGC 0.35 0.79 0.54 0.43ICRGP 0.30 0.83 0.25 0.06ICRGF 0.26 0.60 0.35 0.05ICRGE 0.10 0.52 0.24 0.25

Risk Measure Levels


62

ICRG ratings predict changes in II ratings:

Attribute Coefficient T-Stat R-SquareICRGC 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%


63

Ratings predict inflation:

00.1

0.20.30.40.5

0.60.70.8

0.91

0 20 40 60 80 100

II Rating September 1996

Infl

atio

n ex

pect

atio

ns f

or 1

997


64

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

Per

cap

ita

real

GD

P


65

Time-series of ratings:

0102030405060708090

100

Switzerland Italy Kuwait Argentina


66

Returns and Institutional Investor Country Credit Ratings from 1990

R2 = 0.2976

-0.1

0

0.1

0.2

0.3

0.4

0.5

0 20 40 60 80 100

Rating

Ave

rage

ret

urns

Fit is as good as it gets - lower rating (higher risk) commands higherexpected returns. Even in among US firms, our best model gets about 30% explanatory power.


67

Credit Rating Model

• Intuitive• Can be used in 136 countries, that is, in countries

without equity markets• Fits developed and emerging markets


68

Country Risk Rating ModelSTEPS:

EVR = risk free + intercept - slope x Log(IICCR)• Where Log(IICCR) is the natural logarithm of the

Institutional Investor Country Credit Rating


69

Easy to use:

0%

10%

20%

30%

40%

50%

60%

70%0 10 20 30 40 50 60 70 80 90 100

Rating

Hur

dle

rate

ICRGC IICCR:84 IICCR:79


70

Also predicts volatility:

R2 = 0.5033

0%

10%

20%

30%

40%

50%

60%

70%

0 20 40 60 80 100

Institutional Investor Country Credit Rating

An

nu

aliz

ed V

ola

tility


71

Fitted volatility:

0%

10%

20%

30%

40%

50%

60%

70%

80%

Rating

Exp

ecte

d vo

lati

lity

IICCR:84 IICCR:79


72

And correlation.

R2 = 0.6809

-20%

0%

20%

40%

60%

80%

100%

0 20 40 60 80 100

Institutional Investor Countyr Credit Rating

Co

rrela

tio

n w

ith

MS

CI

AC

Wo

rld


73

Fitted correlation.

-100%

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

Rating

Exp

ecte

d co

rrel

atio

n w

ith

wor

ld

IICCR:84 IICCR:79


74

Asian Crisis.

0102030405060708090

100

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

ICR

G r

atin

g

China Hong Kong India IndonesiaKorea Malaysia Pakistan PhilippinesSingapore Taiwan Thailand Russia


75

Asian Crisis.

60

65

70

75

80

85

90

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

Sep-9

8

ICR

G r

atin

g

Korea Malaysia Russia

Beginning of crisis


76

Value of US$100

020406080

100120140160180200

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

Sep-9

8

Val

ue o

f $1

00


Beginning of crisis


77

Value of local currency (indexed at 100)

0

20

40

60

80

100

120

Jan-9

7

Mar-

97

May

-97

Jul-9

7

Sep-9

7

Nov-9

7

Jan-9

8

Mar-

98

May

-98

Jul-9

8

Sep-9

8

Val

ue o

f $1

00


Beginning of crisis


78


60

65

70

75

80

85

90

95

100

Equally-weighted world G-7xUS Switzerland United States

79

ICRG Political Risk


60

65

70

75

80

85

90

95

100

Equally-weighted world Japan Switzerland United States

80

ICRG Political Risk


60

65

70

75

80

85

90

95

100

Equally-weighted world Japan

Germany Switzerland

United States

81

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

Argentina Mexico Thailand

CAPMIbbotson EHVGS-EHVGS-SegCSFB-EHV

68%

Risk Analysis and Project Evaluation Risk Analysis and Project Evaluation 4. Comparison of Methods

82

-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

CAPMIbbotson EHVGS-EHVGS-SegCSFB-EHV

537%


83

Excel version


84

Risk Analysis and Project Evaluation 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)

85


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)

86


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)

87


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

88


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

89

Risk Analysis and Project Evaluation 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.

90

Risk Analysis and Project Evaluation 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

91

Risk Analysis and Project Evaluation Risk Analysis and Project Evaluation 7. Project Specific Adjustments

Project Risk Analysis

• Operating Risk– Pre-completion– Post-completion– Sovereign

• Financial Risk

92


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.

93


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.

94


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

95


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

96


Operating Risk

• Sovereign Risk (Force Majeure)– Political events

• Wars• Labor strikes• Terrorism• Changes in laws

– Natural catastrophes• Hurricanes/earthquakes/floods


97


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


98

Risk Analysis and Project Evaluation 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 CalculationInputs Output Category

5.02 U.S. risk free in %3.30 U.S. risk premium in %

91.60 Current U.S. Credit Rating38.98 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 Adjustment0.80 Beta (Industry)

-0.66 Sector adjustment

99


Project Risk Mitigation (-10 to 10; where 10=risk completely eliminated, 0=average for country)

Weights Score

Impact on Country Premium

Sovereign0.40 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 partners0.05 5.00 -0.38 Involvement of Multilateral Agencies0.05 0.00 0.00 Sensitivity of Project to wars, strikes, terrorism0.05 0.00 0.00 Sensitivity of Project to natural disasters

Operating0.05 0.00 0.00 Resource risk0.03 0.00 0.00 Technology risk

Financial0.05 2.00 -0.15 Probability of Default0.03 2.00 -0.08 Political Risk Insurance

1.00 Sum of weights (make sure = 1.00)

Project Cost of Capital 14.84

100


Cash Flow Check List:Operating-PrecompletionResources available (quantity/quality) -part not in discount rateTechnology (proven technology) -part not in discount rateTiming risks (penalties for milestones)

Operating-Post-completionMarket risks (prices of outputs)Supply/input risk (availability)Throughput risk (material put through plus efficiency of systems operation)Operating costs

SovereignInflation assumptions/Exchange rates

Real OptionsInput mix or process flexibilityOutput mix or product flexibilityAbandonment or terminationTemporary stop or shutdownIntensity or operating scaleExpansionContractionInitiation or defermentInterproject/intraprojectGrowthShadow costsFinancial flexibilityComplex options which might diminish or augment value of other options

101

Risk Analysis and Project Evaluation 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.

102

Risk Analysis and Project Evaluation: Risk Ratings AppendixRisk Analysis and Project Evaluation: Risk Ratings AppendixPolitical 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 particular locality or region, or are carried out nationwide.

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Risk Analysis and Project Evaluation: Risk Ratings AppendixRisk Analysis and Project Evaluation: Risk Ratings AppendixExternal 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 inexperienced people imposing inappropriate policies through civil dissent to civil war.

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Risk Analysis and Project Evaluation: Risk Ratings AppendixRisk 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 sub-component 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.

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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 0-5%, 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.

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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.

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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.

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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 PremiumRisk Analysis and Project Evaluation: U.S. Risk Premium

0

1

2

3

4

5

6

6-Jun-00 7-Sep-00 4-Dec-00 12-Mar-01 7-Jun-0110-Sep-01 4-Dec-01 11-Mar-02 4-Jun-02 16-Sep-022-Dec-02 19-Mar-03 16-Jun-03 18-Sep-03 10-Dec-0310-Mar-04 10-Jun-04 10-Sep-04 10-Dec-04 10-Mar-05

•Ten-year risk premium is stable. Currently, about 3.2%

Source: Graham and Harvey (2005)

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Risk Analysis and Project Evaluation: The AuthorRisk 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 of the Review of Financial Studies one of the leading publications in finance. In addition, he is an Associate Editor of the Journal of Financial Economics, the Journal of Empirical Finance, the Journal of Fixed Income, the Pacific Basin Finance Journal, the Journal of Banking and Finance, 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.

Risk Analysis and Project Evaluation Campbell R. Harvey Duke University and National Bureau of Economic Research May 2005.

Documents

appendices risk analysis

project evaluation campbell

basic project evaluation

risk worksheet

simple project

project evaluation plan

different risks risk

discount rate slide