Risk Analysis and Project Evaluation - Fuqua School of ...charvey/Teaching/663_2017/... · Risk Analysis and Project Evaluation Campbell R. Harvey ... A. Damodaran, Estimating equity

Risk Analysis and Project Evaluation

Campbell R. HarveyDuke University, NBER and

Investment Strategy Advisor, Man Group, plc

February 1, 2017

International Finance

Campbell R. Harvey 2017 2

3

• Prerequisite to any evaluation of a project is a keen knowledge of both the local and global environments

• Project evaluation requires skills in finance, economics, accounting, political science, psychology, sociology, and history.

• Local knowledge, while necessary, is not sufficient. The local environment is impacted by the global environment.

The Setting

Campbell R. Harvey 2017

4

Global Macro Issues• Shifting of risks from emerging to developed markets• Potential slowing of growth in emerging markets• Transition from partial integration to full• Ugly contests in FX; challenges to fiat currency• Trade wars (tariffs, non‐tariff barriers, border taxes, tax wars)• Commodities and the environment

The Setting


5

The Setting

Wide variation in risk


6

Do Benefits Outweigh the Costs?• Expected cash flows need to be discounted to present value• It is difficult to both forecast the cash flows and determine the appropriate discount rate

• Risk can be reflected in either the cash flows or the discount rate

Goal of Project Evaluation


7

Do Benefits Outweigh the Costs?• Simple example. If project risk free, suppose cash flows are 100 per year, forever, and “risk free rate” is 5%. The value is:

.= 2,000

Numerator and Denominator


8

Do Benefits Outweigh the Costs?• Suppose the project is risky. • Method 1 – Adjust the Cash Flows:



.= 1,000

9

Do Benefits Outweigh the Costs?• Suppose the project is risky. • Method 2 – Adjust the Discount Rate:



.= 1,000

10

Do Benefits Outweigh the Costs?• Our goal is to come to an understanding at both a country and project level of how to adjust for risk

• It does not matter if we adjust the numerator or the denominator

Goal of Project Evaluation


11

What is risk?• There are many different views of risk.



12

Key intuition• If risk can be diversified, then it should not be rewarded. If it is rewarded, then there is an arbitrage possibility.

• Simple model measures risk as the sensitivity to returns on a globally diversified wealth portfolio.

Model 1: CAPM


13

What are the sources of risk?• Common (or systematic) risks. All projects are impacted to some degree by common risks. This impact is called the “beta” or “exposure”

• Idiosyncratic risk. These risk are specific to the project.

Model 1: CAPM


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• Works fine for developed markets if we allow risk to change through time (Harvey 1991)

Model 1: CAPM


15

World CAPM• Fails in most emerging markets• Strong assumptions needed• Perfect market integration• Mean‐variance analysis implied by utility assumptions

Model 1: CAPM


16

• This model is widely used by consultants*• Addresses the problem that the CAPM gives a discount rate too low.• Solution: Add the sovereign yield spread which is the yield spread between a sovereign bond issued in US dollars against a similar maturity US Treasury bond

• Spread is a proxy for “country risk”

Model 2: Sovereign 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.


17

Issues• Ad hoc (no theory) and untested empirically• Bolt‐on to a flawed CAPM• May give unreasonably low cost of equity capital• Any country risk premium reflected in a bond spread will not necessarily reflect the equity premium – because bonds are less risky than equities

Model 2: Sovereign Spread


18

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

Model 2a: Adjusted Sovereign Spread

A. Damodaran, Estimating equity risk premiums, working paper, NYU, undated.Campbell R. Harvey 2017

19

Damodaran

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



20

Damodaran• Advantage: Recognizes that you just can’t use the bond yield spread as a plug number in the CAPM

• Disadvantage: Sovereign spread contains more than “country‐specific” risk



21

Issues:“Since Damodaran’s country risk premium can be neither theoretically nor empirically supported, the rates of return on capital that are derived by such methods are highly arbitrary.”*


Campbell R. Harvey 2017*Kruschwitz, Loeffler and Mandl, 2010, Damodaran’s Country Risk Premium: A Serious Critique.

22


0

10

20

30

40

50

60

70

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2007

2008

2009

2010

U.S. High Yield Spread(bp)

EMBI+ CompositeSpread (bp)

Sovereign spreads and measures of global risk


• Note that US credit spreads are strongly correlated with sovereign spreads

• So sovereign spreads include more than country‐specific information

23

• Empirical model derived from correlating current country credit rating to future equity returns*

• Impressive fit to data (for both developed and emerging markets)

Model 3: Erb, Harvey, Viskanta

*C.B. Erb, C. R. Harvey and T. E. Viskanta, Expected returns and volatility in 135 countries, Journal of Portfolio Management, 1995.Campbell R. Harvey 2017

24


Returns and Institutional Investor Country Credit Ratings from 1990

R2 = 0.2976

-0.1

0.0

0.1

0.2

0.3

0.4

0.5

0 20 40 60 80 100

Rating

Ave

rage

retu

rns


• Just need a slope and an intercept

• Slope is negative ‐0.177 (lower rating means higher risk and higher discount rate)

25

Formula:

Discount Rate = risk free + intercept ‐ slope x Log(IICCR)

• Where Log(IICCR) is the natural logarithm of the Institutional Investor Country Credit Rating



26

Model adopted by Duff & Phelps

World’s leading commercial experts on valuation



27



28



• Notice they implement with local currency returns

29



30

Assume we exactly know the US equity risk premium

• Each quarter the Duke‐CFO survey asks senior US executives for their view of the 10‐year equity risk premium

Model 3a: Adjusted Erb, Harvey, Viskanta


0

1

2

3

4

5

Exce

ss re

turn

fore

cast

%

10-year forecasted S&P 500 (mean) annual returns over and above the 10-year Treasury bond yield

Figure 1a

31

Assume we know the US equity risk premium

• Anchored model exactly delivers the known U.S. risk premium when we put the US country credit rating into the model

• Essentially, we are shifting the line to exactly match one data point that we know



32



[Anchored] C13 = B9+100*(0.898‐0.177*LN(B12)) ‐ ((B9+100*(0.898‐0.177*LN(B11)))‐(B10+B9))

33

Operating Risks: Country Specific

• Sovereign Risk (Macroeconomic)– Exchange rate changes

– Currency convertibility and transferability

– Hyperinflation 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

• Sovereign Risk (Force Majeure)– Political events

• Wars• Labor strikes• Terrorism• Changes in laws

– Natural catastrophes• Hurricanes/earthquakes/floods

34

Operating Risks: Country Specific

• Pre‐completion– Resources available (quality/quantity)

– Technological risk (proven technology?)

– Timing risks (failure to meet milestones)

– Completion risk


• Post‐completion– Market risks (prices of outputs)

– Supply/input risk (availability)

– Throughput risk (material put through plus efficacy of systems operations)

– Operating costs

35

Method• Use adjusted EHV model to get a baseline cost of equity capital for a project of average risk within a country

• Adjust key project‐specific risk exposures if the project’s risks are different from the country average



36



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

Weights Score

Impact on Country Premium

Sovereign0.40 0.00 0.00 Currency (direct, e.g. convertibility)0.10 0.00 0.00 Currency (indirect, e.g. political risk caused by crisis)0.15 0.00 0.00 Expropriation (direct, diversion, creeping)0.05 0.00 0.00 Commercial International partners0.05 0.00 0.00 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 0.00 0.00 Probability of Default0.03 0.00 0.00 Political Risk Insurance

1.00 Sum of weights (make sure = 1.00)

Project Cost of Capital 9.82

37

• There is no textbook agreement on how to measure the cost of equity capital in international markets

• EHV model is the only model that “fits” the data• Nevertheless, best to look at a variety of estimates

Conclusions


38

The Instructor

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. He served as 2016President of the American Finance Association.

Professor Harvey obtained his doctorate at the University of Chicago in business finance. His undergraduate studies ineconomics were conducted at the University of Toronto. He has served on the faculties of the Stockholm School of Economics, theHelsinki School of Economics, and the Graduate School of Business at the University of Chicago. He has also been a visiting scholar atthe Board of Governors of the Federal Reserve System. He was recently awarded an honorary doctorate from SvenskaHandelshögskolan in Helsinki.

Harvey is an internationally recognized expert in portfolio management and global risk management. His work on theimplications of changing risk and the dynamics of risk premiums for tactical asset allocation has been published in the top academic andpractitioner journals. He has published over 125 scholarly articles and books. His work is frequently presented in internationalconferences and is often featured in the business press.

In addition, Professor Harvey has wide‐ranging practical experience. He serves as Investment Strategy Advisor to the ManGroup, the world’s largest listed hedge fund group.

Harvey served as Editor of the Journal of Finance which is the leading scientific publication in the field of finance and thesecond highest rated journal in the economics profession between 2006‐2012.

Harvey has been awarded seven Graham and Dodd Awards/Scrolls for excellence in financial writing from the CFA Institute.Harvey is past winner of the Outstanding Faculty Award at the Fuqua School of Business, an annual award given by the students.


Risk Analysis and Project Evaluation - Fuqua School of ...charvey/Teaching/663_2017/... · Risk Analysis and Project Evaluation Campbell R. Harvey ... A. Damodaran, Estimating equity

Documents