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Journal of

VOLUME 22

|

NUMBER 4

|

FALL 2010

APPLIED CORPORATE FINANCE

A

MORGAN

STANLEY

PUBLICATION

In This Issue: Payout Policy and Communicating with Investors

Financial Planning and Investor Communications at GE (With a Look at Why We Ended Earnings Guidance)

The Value of Reputation in Corporate Finance and Investment Banking (and the Related Roles of Regulation and Market Efficiency)

Maintaining a Flexible Payout Policy in a Mature Industry:

The Case of Crown Cork and Seal in the Connelly Era

Is Carl Icahn Good for (Long-Term) Shareholders?

A Case Study in Shareholder Activism

Drexel University Center for Corporate Governance Roundtable on Risk Management, Corporate Governance, and the Search for Long-Term Investors

Blockholders Are More Common in the United States Than You Might Think

Private Equity in the U.K.: Building a New Future

Should Asset Managers Hedge Their “Fees at Risk”?

Measuring Corporate Liquidity Risk

The Beta Dilemma in Emerging Markets

Liquidity Risk The Beta Dilemma in Emerging Markets 8 Keith Sherin, General Electric 18 Jonathan

8

Keith Sherin, General Electric

18

Jonathan Macey, Yale Law School

30

James Ang, Florida State University, and Tom Arnold, C. Mitchell Conover, and Carol Lancaster, University of Richmond

45

Vinod Venkiteshwaran, Texas A&M University-Corpus Christi, and Subramanian R. Iyer and Ramesh P. Rao, Oklahoma State University

58

Panelists: Scott Bauguess, U.S. Securities and Exchange Commission; Jim Dunigan, PNC Asset Management Group; Damien Park, Hedge Fund Solutions; Patrick McGurn, Risk Metrics; Don Chew, Morgan Stanley. Moderated by Ralph Walkling, Drexel University.

75

Clifford G. Holderness, Boston College

86

Mike Wright, Center for Management Buy-out Research and EMLyon, and Andrew Jackson and Steve Frobisher, PAConsulting Group Limited and Center for Management Buy-out Research

96

Bernd Scherer, EDHEC Business School, London

103

Håkan Jankensgård, Lund University

110

Luis E. Pereiro, Universidad Torcuato Di Tella

Electronic copy available at: http://ssrn.com/abstract=1873316

The Beta Dilemma in Emerging Markets

The Beta Dilemma in Emerging Markets

by Luis E. Pereiro, Universidad Torcuato Di Tella*

T
T

he Capital Asset Pricing Model1 (“CAPM” henceforth) has provided both equity investors and corporate officers making direct investment

decisions with a way to estimate present values and expected returns on investments. The CAPM framework provides financial practitioners with a measure of beta (or “systematic risk”) for entire stock markets, for industry sub- sectors, and for individual equities. Betas represent the way a particular asset’s returns (or an industry’s returns) co-vary with the returns of a broad market index. Typically, the beta of a U.S. equity is measured against changes in the Standard & Poor’s 500 stock index. Betas of equities in other countries are usually measured against changes in local stock market indices. CAPM can provide a useful estimate of a firm’s cost of capital even if that firm does not have publicly traded shares to provide a measure of risk. Groups of similar firms (perhaps in the same industry) that do have listed shares can provide a good proxy for the risk a private firm faces. When combined with (1) some “risk-free rate” (usually assumed to be the yield on the relevant sovereign debt), (2) a “market risk premium” (the annualized rate by which local equity investors have outperformed local debt investors over long periods of time) and (3) a company-specific leverage factor, the beta of an equity can tell an investor what rate of return that investment should achieve. This same rate should also function as a “hurdle rate” corporate decision-makers use to assess the desirability of a particular direct investment and for someone trying to price a private asset in an emerging market. In principle, the CAPM is universally applicable to invest- ments. In practice though, decision-makers face at least two serious predicaments in applying CAPM logic to emerging market investment assets. The first is a data predicament—that is, relevant local data may not exist, or it can turn out to be undependable or atypi- cal. If you try to use a pricing model based on local (domestic)

industry betas, you may find that some markets simply have no companies quoting in certain industries, and therefore, no industry betas will be available at the domestic level. For example, neither Brazil nor Russia has locally-quoted biotechnology companies. In other markets, the local price series available to compute betas are unacceptably short— therefore, betas will be unreliable. In still others, even if you do find a reliable industry beta, it may still not fairly reflect the risk of its industry if the sector in question weighs heavily and disproportionately in the local market’s capitalization. In Argentina, for example, a single industry, oil, accounts for 40% of total domestic market cap; in South Africa, the mining sector makes up close to 24% of local market cap; in Slovenia, the pharmaceutical industry (itself made up of a single company) represents more than one third of the local market cap. In such cases, the beta of the sector at the top of the market cap list is reflecting market, rather than industry, risk, and will not be a fair gauge of the true sector’s risk.2 To avoid the data predicament, many value appraisers simply resort to using U.S. betas as surrogates for emerging market (EM) betas. In Argentina, 67% of financial advisors and private equity funds do so when valuing local compa- nies; only 14% of them apply some kind of corrective process to U.S. data before computing a domestic cost of capital.3 Unfortunately, U.S. beta fans bump on the other side of the dilemma against an equivalence predicament—namely, are local industry betas equivalent across borders? Intuition suggests they need not be, simply because an EM industry could well be in a different stage of develop- ment than its U.S. counterpart—and thus command a very different level of risk.4 Demand for, say, soft drinks could be more sensitive to an economic recession in Latvia than in the U.S.; the risk—and therefore the beta—of the soft drink industry in Latvia should then be larger. Industry betas may also differ across borders due to dissimilar levels of operating and financial leverage. Despite the intuition that cross-border differences in domestic betas may exist, we still lack the empir- ical research needed for verification and, as a consequence, the

* I would like to thank Aswath Damodaran, Martín González-Rozada, Javier Estrada, Nora Sánchez and Gustavo Vulcano for useful comments and suggestions. Lucía Freira provided valuable research assistance. The views expressed below and any errors that may remain are entirely my own.

110 Journal of Applied Corporate Finance Volume 22 Number 4

1. Sharpe, William F. (1964). “Capital Asset Prices—A Theory of Market Equilibrium

Under Conditions of Risk.” Journal of Finance XIX (3): 425–42.

2. For additional examples, see Zenner and Akaydin (2002).

3. Pereiro (2006).

4. Damodaran (2002); Shapiro (2003).

A Morgan Stanley Publication Fall 2010

Electronic copy available at: http://ssrn.com/abstract=1873316

equivalence predicament keeps haunting the analyst. This article proposes a solution to the beta dilemma. The data predicament is negotiated first, by computing domestic industry betas for a long list of EMs considered as a unique asset class. The procedure allows us to find a sizable number of betas per industry, for a large number of industries, thus automati- cally diluting the data predicament. We next attend to the equivalence problem by formally testing whether domestic EM and U.S. industry betas are fair proxies for each other; such tests will clearly inform value appraisers on when it is sensible to assume equivalence—and when it isn’t.

Solving the Data Predicament To calculate the cost of equity of an emerging-market company, many value appraisers resort to CAPM-based models that employ domestic industry betas (see Exhibit 1, Panel A for a brief review). These models, however, work well only if a local industry beta is available, is reliable, and is truly representa- tive of its sector. In many EMs, alas, such betas are simply not there, and analysts choose to use as a reference the beta of a different emerging market, whose industry plausibly shares the risk-return pattern of the target’s. In many cases, though, this strategy will still be to no avail: local betas in the alternate country may still be lacking, undependable, or atypical. The data predicament can be approached by aggregating EMs into a single asset class. Such grouping, which allows for finding a large enough number of valid industry betas, is predicated on the fact that, in contrast to the U.S., emerging stock markets share a number of risk-related characteristics:

small absolute and relative size, low liquidity, higher leverage, heavy concentration, and high volatility. China, nowadays the center of gravity of Asian markets, represents less than 19% of U.S. market cap; India, less than 9%; and Brazil, less than 6%. The importance of EMs in their respective economies is likewise smaller: the median weight of the stock market as a percentage of GNP is about 40% in EMs; the figure in the U.S.: 180%. Smallness goes hand in hand with lower liquid- ity, which in EMs is only one third of the U.S.’s.5 The median market debt-to-assets ratio is 16.6% in EMs and 15.4% in the U.S. Add to that concentration—which can and often does lead to price manipulation: the top 10 largest firms in EMs represent about 56% of total market cap; in the NYSE, the figure is 23%.6 Finally, EM returns march alongside large volatilities: the long-term annual return in the U.S. is 8.1%, at an annual volatility of 16.2%; the return figure for EMs is about 9.1% a year—at an annual volatility of 34.8%.7 Similar

risk features across EMs are so contrasting to those in the U.S., that we feel justified in grouping EMs into a single, distinctive asset class—which is exactly what international portfolio managers have been doing for years. To illustrate the aggregation procedure, we defined EMs as a broad asset class comprising 81 stock markets,8 and collected the betas of all their public firms by January 1st, 2010. Betas had been computed by Bloomberg over a 5-year window by regressing weekly U.S.-dollar based returns on the most important local index. For the U.S., the original data came from ValueLine, betas being computed over a 5-year window by regressing weekly returns against the NYSE Composite Index. We purified the data by eliminat- ing companies in financial distress (as signaled by a zero or negative book value of equity, or by a negative book- to-equity ratio), and finally screened out companies with nil or negative betas, which are useless for cost-of-capital computations. Observable firm betas reflect the current financial lever- age of the firms in question, and are therefore financially levered betas. From these we cleansed the effect of financial leverage by computing unlevered firm betas:

Unlevered Beta = Levered Beta / [1+ (1-T) x D/E]

(1)

where T is the corporate tax rate, and D/E is the market- marked financial leverage of the firm in question.9 We are interested in unlevered betas since these are, for private firms, the standard starting point in cost-of-capital computations:

the unlevered beta is re-levered with the D/E ratio of the firm under valuation and introduced into any of the models avail- able for cost-of-capital calculations. Going a step further, we computed total firm betas. A total beta gauges the total risk of a stock (i.e., that stock’s systematic plus unsystematic risks); it is defined as the full volatility of the stock relative to the market’s:

Total Beta= [Standard Deviation of Firm’s Stock Returns / Standard Deviation of Market’s Returns]

(2)

We are interested in total beta because it is a most useful risk measure for undiversified investors—e.g., private-firm owners whose wealth is concentrated into a single stock and thus bear the handicap of nil diversification. Also, total beta works well as a maximum extreme reference for partially diversified inves- tors—i.e., those whose portfolios comprise just a few stocks

5. Based on data from Lesmond (2005) and Lesmond, Ogden and Trzcinka (1999).

6. Pereiro (2001a).

7. Computed over 1920–1996 by Goetzmann and Jorion (1999).

8. The class included, in fact, a mixture of emerging, frontier, and less-developed

stock markets: Argentina, Bahamas, Bahrain, Bangladesh, Bermudas, Bolivia, Botswa- na, Brazil, Bulgaria, Cayman, Chile, China, Colombia, Costa Rica, Croatia, Cyprus, Czech Republic, Dominican Republic, Ecuador, Egypt, El Salvador, Estonia, Fiji, Ghana, Guatemala, Hong Kong, Hungary, India, Indonesia, Iran, Israel, Ivory Coast, Jamaica,

Jordan, Kazakhstan, Kenya, Kuwait, Latvia, Lebanon, Liberia, Lithuania, Malawi, Malay- sia, Mauritius, Mexico, Morocco, Namibia, Nicaragua, Nigeria, Oman, Pakistan, Pales- tine, Panama, Paraguay, Peru, Philippines, Poland, Qatar, Romania, Russia, Saudi Ara- bia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Sri Lanka, Swaziland, Taiwan, Thailand, Trinidad, Tunisia, Turkey, U.A.E., Ukraine, Uruguay, Ven- ezuela, Vietnam, Zambia, and Zimbabwe. We call the whole class “emerging” for sim- plicity. 9. This is the classic Hamada’s (1972) formula.

and thus bear the handicap of partial, or incomplete, diver- sification; for these investors, true betas will lie somewhere between regular and total betas. (Since totally or partially undiversified investors are legion,10 analysts have developed several models to deal with their special diversification status; some appear in Exhibit 1, Panel A.) Total betas can be computed from regular betas by using the following equation:

Total Unlevered Beta = [Unlevered Beta / Rho]

(3)

where Rho is the correlation coefficient of the stock’s return against the market’s.11 Rho is a simple measure of how sensitive a particular stock’s return is to general economic conditions, as reflected in the stock market. The next-to-last step was to group betas and total betas according to industry. Since Bloomberg and Value Line classify industries differently, we constructed our own set of catego- ries by checking out each company’s SIC/NAICS number and, when necessary, resorting to individual company reports, to properly sort each firm into the right industry. Finally, we computed industry medians for betas and total betas. The median is a standard measure of centrality widely used in corporate valuation because it is impervious to outliers (in contrast to arithmetic means; outliers frequently crop up in beta samples). After discarding sectors with fewer than 10 firms, we were left with 66 industries whose betas and total betas appear in Exhibits 2 and 3, respectively. Courtesy of the aggregation procedure, the value appraiser can simply look into our tables to find a plausible industry beta for an emerging market. Since our betas have been computed against local market indexes, they should be reflecting domestic industry risk fairly well, thus being the perfect fit for models that employ local betas. The aggregation solution works well, of course, only if one believes that the industry beta of the average EM is a good match for its analogue in the specific emerging market (say, Latvia) in which the target company operates. If not, one may well be facing an industry whose risk-return dynamics (and beta) are instead akin to those of developed markets; being the U.S. a good proxy for the latter, in such cases one could

apply, without further regrets, a pricing model that employs

a straight U.S. beta (see Exhibit 1, Panel B, for a brief review

of these models).

Solving the Equivalence Predicament Another way to solve the data predicament would be to

apply U.S. domestic betas directly to EMs; but this strategy

is fraught with danger because local industry betas may not

be equivalent across asset classes.12 The last column in Exhibit 2 shows that close to 80% of industry betas are not equiva- lent across classes. Consequently, we can justify using U.S. betas as sensible surrogates for domestic EM betas for only a handful of industries. Look next at the results reported in the last column

of Exhibit 3: total betas turn out to be significantly differ-

ent between asset classes for about 30% of the sample. The overall conclusion is telling: U.S. betas should not be directly applied to EMs unless cross-border beta equivalence has been adequately proven in the first place.

Fickle Risk, Beta Waves

A closer look at Exhibit 2 reveals a striking find: all industry

betas that are significantly different across classes are smaller

in EMs. In fact, the median of medians in EMs is 0.37—less

than half the U.S. norm of 0.84. Since differences in develop- ment, or in operating leverage, may produce larger or smaller betas across asset classes, our consistent find of smaller betas in EMs is somewhat troubling. Is there a problem in the data? The problem is not in the data, but in the fact that betas and total betas are inter-temporally unstable risk measures—i.e., they change over time. A stock’s risk, as noted, has several components: the degree of operating leverage; the potential obsolescence of the product or service offered; the strength of the competition; the position of the industry in its life cycle (which affects the sensitivity of the demand to economic conditions); the vulnerability of

operations to external financing via credit or equity (in a dry market, financing is difficult or impossible); and even investor sentiment. All these components are bound to vary as time elapses, and so are risk metrics—betas and total

betas.13

10. The existence of imperfectly diversified investors has been reported on: majority shareholders in family-owned companies (Moskowitz and Vissing-Jorgensen, 2002); venture capitalists (Norton and Tenenbaum, 1993; Schertler, 2001); angel investors

(Freear, Sohl and Wetzel, 1997; Pereiro, 2001b); individuals investing in the U.S. stock market (Blume and Friend, 1975; Lease, Lewellen and Schlarbaum, 1976; Barber and Odean, 2000; Huberman, 2001; Ivkovic and Weisbenner, 2003); corporate employees (Benartzi, 2001); and international portfolio managers (Karolyi and Stulz, 2002).

11. Let R T = Alpha + Beta. R M ; where R T is the total return of the stock and R M the

market return. V(R T )= Beta 2 . V(R M ), where V is the variance. On the other hand, V(R T ) can be de-composed in one systematic and one unsystematic risk components, like this:

V(R T )= R 2 .V(R T ) + (1-R 2 ). V(R T ). Using both identities: V (R T )= Beta 2 . V(R M ) = Rho 2 . V(R T ), from where V(R T ) = Beta 2 . V(R M )/Rho 2 . Extracting the square root in both terms:

Standard Deviation (R T ) = (Beta/Rho). Standard Deviation(R M ). From where the beta of the total return, or total beta, is (Beta/Rho).

12. Testing for equivalence is akin to testing the difference of medians. The most

powerful difference-of-medians test is Pearson’s t-test but, being parametric, it can be

used only if betas are normally distributed in both asset classes. We used the Shapiro- Wilk (S-W) test to test for such dual normality and applied the t-test only to those indus- tries in which the condition verified. (By definition, the t-test tests differences between means, not medians; yet in normally-distributed data, mean and median coincide be- cause of symmetry, therefore testing means is equivalent to testing medians—which is our goal). Where dual normality was not present, we applied a non-parametric test—the Wald-Wolfovitz (W-W) Runs, a tool that tests not only the location (median) of the distri- bution but also its shape—hence being a very comprehensive test. The choice of the S-W and W-W tests is predicated on the fact that they work better for small samples—fewer than 2,000—which are the norm in industry beta datasets. A good tip is to use always exact tests of significance, since these can handle small samples, sparse tables, and unbalanced designs—features that are likely to appear in many an industry. 13. Financial leverage is also a risk component, but we have cleansed its effects from our data by working with unlevered betas.

How, exactly, have betas been evolving lately? Exhibit 4 lets us peek at the answer: between 2007 and 2010, the median of medians for U.S. industry betas remained fairly stable (it climbed slightly from 0.83 to 0.85, but the change was statistically insignificant); while the median in EMs dropped sharply—from 0.94 to 0.39, a highly significant difference. In other words, EMs became less risky on average over that period. Panels B1 and B2 in Exhibit 4 graphically reinforce our argument: the beta probability distribution—or beta ‘wave’—stays in about the same place in the U.S., but shifts dramatically to the left (i.e., to less risky terrain) in EMs. It is this shift, precisely, that may be accountable for our finding that all industry betas were, as of the dawn of 2010, smaller in EMs than in the U.S. As for total industry betas, some turn out to be larger in the U.S., and some others don’t; but in any case, U.S. median total beta increased significantly—going from 1.66 in January 2007 to 2.36 in January 2010. In consonance, Panels B3 and B4 in Exhibit 4 illustrate how the total beta wave in the U.S. displaces heavily to the right, i.e., to riskier terrain. The reason behind this shift has almost certainly been the subprime credit crisis.14 In stark contrast, the median total beta for EMs decreased over the same period—shifting signifi- cantly from 2.44 to 2.02. How come U.S. total beta increased while U.S. beta remained stable? The answer lies in the evolution of Rho—the correlation. Recall that beta equals total beta divided by Rho. Over the time stretch under analysis, U.S. total beta went up while Rho went down—in such a way that beta was left virtually unscathed. Not in EMs, though:

here, while Rho likewise decreased over time, on balance, beta decreased significantly. Now, since Rho went down in both the U.S. and EMs, it seems that in both asset classes, the idiosyncratic, or non-diversifiable portion of total risk prevailed over the market-related portion (i.e., that measured by beta).

In summary, betas and total betas do change over time with the gyrations of stock markets, and this warrants a stern caveat: if we employ the aggregation procedure to solve the data predicament, we must take the precaution to update our datasets from time to time.

Asset Pricing with the Beta Solution The choice of a cost of equity model for an emerging-market firm is very personal: it depends on how conceptually sound the model looks to the analyst, and on her view on which risks can—and which cannot—be diversified away by the investor. The choice done, the analyst faces the challenge of finding a plausible beta to plug into the selected model—and at this point is when the solution to the beta dilemma becomes help- ful (see Exhibit 5). Those who prefer using local pricing models but are unable to find plausible local betas in the emerging market, can use the industry beta of (a) another EM, suspected to have a similar risk-return industry dynamics (and, as long as such beta is available, reliable, and representative); or (b), as we have argued, the beta of the whole EM class. Relying on U.S. betas head-on is, we explained, a dangerous approach, since betas may be significantly different across classes. If the risk-return dynamics of the industry in the target EM is suspected to be different from that of the EM class as a whole, why not assume that such market is rather follow- ing the dynamics of developed markets? Being the U.S. the epitome of such, using a U.S.-beta-based pricing model will be a fair strategy to apply in such occasions. All in all, solving the beta dilemma clarifies when it is sensible to use a local, and when a U.S.-based, asset pricing model.

luis e. pereiro is Professor of Finance at the Business School, Univer- sidad Torcuato Di Tella in Buenos Aires, Argentina. He is also the author of Valuation of Companies in Emerging Markets: A Practical Approach, John Wiley & Sons (2002).

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Lesmond, D., Ogden, J., Trzcinca, C. (1999). “A New Estimate of Transaction Costs.” Review of Financial Studies, 12, 1113–1141. Lessard, D. (1996). “Incorporating Country Risk in the Valuation of Offshore Projects.” Journal of Applied Corporate Finance, 9, 52–63. Mariscal, J.O. and K. Hargis (1999). “A Long-Term Perspective on Short-Term Risk.” Goldman Sachs Invest- ment Research. Moskowitz, T.J. and A. Vissing-Jorgensen (2002). “The Returns to Entrepreneurial Investment: A Private Equity Premium Puzzle?” American Economic Review, 92,

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Appendix

Exhibit 1 CAPM-Based Cost of Equity Models Used in Emerging Markets Valuation

Panel A

Models Using Local (Domestic) Betas

Model

Description

1. Local CAPM (L-CAPM);

adapted from Pereiro (2001a)

C E = R f US + R C + B LL . (R M L – R f L )

where C E is the cost of equity capital, R f US is the U.S. risk-free rate, R C is a country risk premium, B LL is the beta of a comparable local company (or industry) computed against a local (i.e., emerging) market index, and R M L the return of the local stock market. The country risk premium R C is usually computed as the spread of dollar-denominated sovereign bonds over American T-bonds of similar denomination, yield and term. This model fits a partially diversified investor: the use of beta suggests the investor is fully diversified at the domestic company (or industry) level, but unable to diversify at the country level.

2. Adjusted Local CAPM (AL-CAPM);

adapted from Pereiro (2001a)

C E = R f US + R C + B LL . (R M L – R f L ) . (1 - R 2 )

where R 2 may be thought of as the amount of variance in the equity volatility of the target company that is explained by country risk. This model is an improvement over the Local CAPM, since the last term compensates for the double-counting of country risk implied in using both R C and R M L in the same equation. Again, the model fits a partially diversified investor:

well-diversified at the local firm (or industry) level, but unable to diversify at the country level.

3. Full Risk Adjusted Local CAPM

(FRAL-CAPM)

C E = R f US + R C + BT LL . (R M L – R f L ) . (1 - R 2 )

where BT LL is the total beta of a comparable local company (or industry) computed against a local market index. BT is computed as the standard deviation of the return of a local comparable company (industry), divided by the standard deviation of the return of the local market. This model is conceptually equivalent to the AL-CAPM but applies instead to fully undiversified investors, since a total beta is used.

4. Full Risk Hybrid Local CAPM

(FRHL-CAPM)

C E = R f US + BT LL . (R M US R f

In this model, country risk is incorporated by calibrating the U.S. market risk premium to the local (emerging) market via

a total country beta, or BT L,US , equal to the standard deviation of returns in the local equity market divided by the standard deviation of returns in the U.S. market. Since the R C factor is not used, no correction for risk double-counting is needed. The model is hybrid in the sense that it combines EM data with U.S. data. Like the FRAL-CAPM, this model applies to fully undiversified investors—i.e., to those unable to diversify company, industry, and country risk.

US ) . BT L,US

5. Goldman-Sachs (G-S) Model;

adapted from Mariscal and Hargis

(1999)

C E = R f US + R C + B LL . (R M US – R f US ) . BT L,US . (1 – R) + R Id

where RM US is the return of the U.S. stock market index, and R is the correlation of dollar returns between the local stock market and the sovereign bond used to measure country risk. While (1-R) is used to alleviate the problem of double counting country

risk, the problem is not fully solved, since the model also includes BT L,US in the same equation. A special feature of the model is

R Id , an idiosyncratic risk premium related to the special features of the target firm (e.g., specific firm credit rating as embodied

in its corporate debt spread, industry cyclicality, percentage of revenues coming from the target country, etc). This model fits a partially diversified investor: the use of B LL suggests the investor is well diversified at the local company (or industry) level, but

unable to diversify at the country level.

6. Gamma Model; Damodaran (2002)

C E = R f US + R C . Gamma + B LL . (R M US – R f US ) where Gamma is a firm-specific exposure to country risk ranging from zero to one, and B LL is the local company beta computed against a local market index. The exposure factor Gamma could be, for instance, the percentage of revenues to the parent firm coming from the local (emerging) market. The use of the R C factor suggests, again, that the investor is unable to diversify country risk; yet the use of B LL suggests the investor is able to diversify company (or industry) risk.

Panel B

Models Using U.S. Betas

Model

Description

7. Lessard´s Model Lessard (1996)

C E = R f US + R C + BC L,US

. B US . (R M US R f US )

where R C is a country risk premium that includes the chance of expropriatory actions, payment difficulties and other risks, BC L,US is the country beta (the relative sensitivity of the returns of the local stock market to the U.S. market’s), and B US is the beta of a U.S.-based project whose risk pattern is comparable to the offshore project. The country risk premium can be computed as a sovereign bond yield spread against U.S. treasuries, as an OPIC insurance premium, or indirectly derived from political risk ratings. The simultaneous use of R C and BC L,US without any further correction suggests the model double-counts country risk. The use of a U.S. beta suggests the investor is well-diversified at the firm (or industry) level, but unable to diversify at the country level. This model (and all other models within this panel) implicitly assumes that a U.S. firm (or

industry) beta is a plausible surrogate for the local EM beta.

8. Adjusted Hybrid CAPM (AH-CAPM)

(adapted from Pereiro, 2001a)

C E = R f US + R C + BC L,US

. B US . (R M US – R f US ) . (1 – R 2 )

where B US is the average unlevered beta of comparable companies quoting in the U.S. market, relevered with the financial structure of the target company, and R 2 is the coefficient of determination of the regression between the equity volatility of the local market against the variation in country risk. Conceptually similar to Lessard’s model, but attempts to correct for the double counting of country risk by including the (1 - R 2 ) factor. R 2 can be thought of as the amount of variance in the volatility of the local equity market that is explained by country risk. Like Lessard’s, this model applies to an investor that is well-diversified at the firm (or industry) level, but unable to diversify at the country level.

9. Full Risk Hybrid U.S. CAPM (FRHUS-CAPM)

C E = R f US + BT US . (R M US – R f

This model is identical to the FRHL-CAPM, except that it uses a total U.S. beta instead of a total local beta. BT US is the total beta of a comparable U.S. company (or industry) computed against the U.S. market index. Like the FRHL-CAPM, this model incorporates country risk by calibrating the U.S. market risk premium to the local (emerging) market via the total country beta BT L,US . In this aspect, the model is similar to the G-S model; but in contrast, the Rc factor is not used here, and that’s why no correction for risk double counting is needed. Like the FRAL- and FRHL-CAPMs, this model applies to fully undiversified investors—i.e., to those unable to diversify company, industry, and country risks. The model uses a total U.S. beta which, as this article purports, may not necessarily be a good proxy for its emerging market counterpart.

US ) . BT L,US

Exhibit 2 Betas: Industry Medians in Emerging Markets and the U.S. Market, 2010

This exhibit shows industry medians of unlevered betas for 66 sectors as of January 1, 2010. Industries with betas normally distributed in both EM and U.S. data have been tested with the t-test; all others have been tested with the Wald-Wolfovitz (W-W) Runs test. Significances of 0.1 or smaller lead to reject the null hypothesis that median betas in EMs and the U.S. are not statistically different. The median of medians in EMs, 0.37, is signifi- cantly different from the U.S.’s, 0.84 (W-W statistic: -7.864; significance: 0.00).

Unlevered Betas

Tests of Normality:

Test of the Difference of Medians:

 

Shapiro-Wilk Significance

 

Significances

Industry

N EM

N US

EM Betas

US Betas

Both

t-test

W-W Test

 

Beta EM

Beta US

Medians

 

normal?

different?

Advertising

26

18

0.40

0.90

0.00

0.09

No

-

0.01

Yes

Aerospace/Defense

21

51

0.31

0.80

0.01

0.04

No

-

0.00

Yes

Air transportation

43

34

0.37

0.53

0.00

0.34

No

-

0.50

No

Apparel/Textile

325

37

0.32

0.90

0.00

0.65

No

-

0.00

Yes

Auto parts

156

35

0.35

1.05

0.00

0.05

No

-

0.00

Yes

Auto/Truck

45

15

0.31

0.73

0.00

0.55

No

-

0.01

Yes

Beverages

84

27

0.31

0.58

0.00

0.71

No

-

0.02

Yes

Biotechnology

28

54

0.41

0.90

0.12

0.31

Yes

0.00

0.01

Yes

Building materials

97

39

0.29

0.83

0.00

0.27

No

-

0.01

Yes

Cable TV/TV/Radio

43

13

0.46

0.66

0.00

0.30

No

-

0.78

No

Chemical-Basic

248

13

0.35

1.12

0.00

0.34

No

-

0.00

Yes

Chemical-Diversifed

48

25

0.31

0.97

0.00

0.46

No

-

0.00

Yes

Chemical-Specialty

171

65

0.37

0.88

0.00

0.81

No

-

0.00

Yes

Coal

37

17

0.61

1.33

0.00

0.84

No

-

0.05

Yes

Computer-Hardware/Equipment

189

86

0.43

0.94

0.00

0.42

No

-

0.00

Yes

Computer-Software/Services

405

228

0.52

0.85

0.00

0.00

No

-

0.00

Yes

Construction-Heavy/Engineering

396

12

0.40

1.20

0.00

0.94

No

-

0.13

No

Construction-Residential/Commercial

185

25

0.30

0.36

0.00

0.02

No

-

0.49

No

Cosmetics/Personal care

25

13

0.39

0.82

0.03

0.19

No

-

0.02

Yes

Educational services

18

25

0.31

0.63

0.05

0.04

No

-

0.04

No

Electric utility

175

60

0.24

0.44

0.00

0.00

No

-

0.00

Yes

Electrical equipment

258

63

0.40

0.95

0.00

0.81

No

-

0.00

Yes

Electronics

457

148

0.44

0.89

0.00

0.00

No

-

0.00

Yes

Entertainment

48

49

0.36

0.69

0.00

0.36

No

-

0.02

Yes

Environmental

39

50

0.58

0.65

0.00

0.13

No

-

0.15

No

Financial services-Brokerage/Investment banking

103

22

0.46

0.99

0.00

0.02

No

-

0.03

Yes

Financial services-Diversified

83

125

0.28

0.71

0.00

0.03

No

-

0.00

Yes

Food-Processing

303

82

0.32

0.61

0.00

0.35

No

-

0.08

Yes

Food-Retail/Supermarkets

25

15

0.36

0.59

0.00

0.83

No

-

0.02

Yes

Food-Wholesalers

16

13

0.44

0.44

0.12

0.15

Yes

0.82

0.52

No

Furniture/Home decoration

80

28

0.36

0.85

0.00

0.95

No

-

0.02

Yes

Hotel/Casino

168

46

0.40

0.82

0.00

0.17

No

-

0.07

Yes

Exhibit 2 continued

Unlevered Betas

 

Tests of Normality:

Test of the Difference of Medians:

 

Shapiro-Wilk Significance

 

Significances

Industry

N EM

N US

Beta EM

Beta US

EM Betas

US Betas

Both

t-test

W-W Test

Medians

 

normal?

different?

Household products

75

20

0.27

0.71

0.00

0.33

No

-

0.00

Yes

Industrial services

186

115

0.32

0.72

0.00

0.42

No

-

0.00

Yes

Information services

16

19

0.67

0.85

0.67

0.16

Yes

0.22

0.16

No

Internet

89

99

0.66

0.93

0.01

0.05

No

-

0.01

Yes

Machinery

278

93

0.39

0.93

0.00

0.16

No

-

0.00

Yes

Maritime transportation

118

47

0.33

0.57

0.00

0.06

No

-

0.16

No

Medical services

52

102

0.31

0.75

0.01

0.08

No

-

0.00

Yes

Medical supplies

48

176

0.48

0.81

0.00

0.00

No

-

0.00

Yes

Metal fabricating

45

26

0.31

1.03

0.00

0.29

No

-

0.01

Yes

Mining

168

68

0.53

1.16

0.00

0.25

No

-

0.00

Yes

Natural gas

47

72

0.40

0.54

0.00

0.02

No

-

0.03

Yes

Office Equipment/Supplies

29

16

0.36

0.77

0.06

0.48

No

-

0.00

Yes

Oilfield services/equipment

106

93

0.38

1.06

0.00

0.35

No

-

0.00

Yes

Oil-Integrated

19

24

0.69

0.98

0.97

0.17

Yes

0.01

0.20

No

Oil-Producing

33

126

0.69

0.98

0.22

0.16

Yes

0.08

0.74

No

Packaging/Container

85

24

0.26

0.76

0.00

0.31

No

-

0.00

Yes

Paper/Forest products

104

29

0.32

0.76

0.00

0.29

No

-

0.00

Yes

Pharmaceuticals

224

179

0.38

0.85

0.00

0.50

No

-

0.00

Yes

Pharmacy services

24

16

0.33

0.71

0.00

0.09

No

-

0.00

Yes

Printing/Publishing

66

18

0.33

0.85

0.00

0.83

No

-

0.08

Yes

Real Estate-Services/Development

516

13

0.36

0.55

0.00

0.55

No

-

0.72

No

Recreation/Leisure time

50

46

0.37

0.72

0.00

0.90

No

-

0.00

Yes

Retail Store

184

159

0.42

0.86

0.00

0.00

No

-

0.00

Yes

Retail-Automotive

21

14

0.20

0.76

0.02

0.08

No

-

0.00

Yes

Retail-Restaurant

32

55

0.46

0.78

0.48

0.33

Yes

0.00

0.10

Yes

Semiconductor

247

98

0.51

1.04

0.00

0.00

No

-

0.00

Yes

Semiconductor equipment

87

13

0.49

1.05

0.00

0.41

No

-

0.00

Yes

Shoe

22

17

0.51

0.94

0.11

0.98

Yes

0.00

0.78

No

Steel

199

31

0.36

1.10

0.00

0.12

No

-

0.00

Yes

Telecom-Equipment

198

81

0.53

0.85

0.00

0.11

No

-

0.00

Yes

Telecom-Services

86

87

0.37

0.66

0.00

0.26

No

-

0.35

No

Telecom-Wireless/Cellular/Satellite

49

38

0.37

1.00

0.00

0.04

No

-

0.00

Yes

Trucking

39

31

0.28

0.85

0.00

0.21

No

-

0.01

Yes

Water utility

32

13

0.23

0.49

0.00

0.00

No

-

0.01

Yes

Total (66 industries)

7,919

3,591

Minimum

0.20

0.36

Maximum

0.69

1.33

Mean of Medians

0.39

0.82

Median of Medians

0.37

0.84

Exhibit 3 Total Betas: Industry Medians in Emerging Markets and the U.S. Market, 2010

This exhibit shows median unlevered total betas for 66 industries as of January 1, 2010. All industries in the exhibit have non-normally distributed betas in EM, the U.S. or both; and have therefore been tested with the Wald-Wolfovitz (W-W) Runs test. Significances of 0.1 or smaller lead to reject the null hypothesis that median total betas in EMs and the U.S. are not statistically different. The median of medians in EMs, 2.16, is not significantly different from the U.S.’s, 2.45 (W-W statistic: -5.24; significance: 0.30).

Unlevered Total Betas

Tests of Normality:

Shapiro-Wilk Significance

Test of the Difference of Medians: Significances

Industry

N EM

N US

Total

Total

EM Total Betas

US Total Betas

Both

W-W Test

Medians

 

Beta EM

Beta US

normal?

different?

Advertising

26

14

2.36

3.25

0.23

0.00

No

0.50

No

Aerospace/Defense

20

45

2.79

2.39

0.00

0.00

No

0.14

No

Air transportation

41

28

1.44

1.89

0.00

0.00

No

0.75

No

Apparel/Textile

291

34

2.34

2.89

0.00

0.00

No

0.40

No

Auto parts

145

28

2.15

2.88

0.00

0.51

No

0.03

Yes

Auto/Truck

41

15

2.59

1.87

0.00

0.15

No

0.51

No

Beverages

75

25

1.82

1.83

0.00

0.00

No

0.17

No

Biotechnology

25

45

2.74

3.53

0.00

0.00

No

0.05

Yes

Building materials

87

32

2.14

2.36

0.00

0.05

No

0.43

No

Cable TV/TV/Radio

40

11

1.96

1.73

0.00

0.07

No

0.30

No

Chemical-Basic

226

12

2.39

3.04

0.00

0.29

No

0.80

No

Chemical-Diversifed

46

23

2.55

2.29

0.03

0.00

No

0.03

Yes

Chemical-Specialty

153

58

2.29

2.46

0.00

0.00

No

0.56

No

Coal

35

16

4.17

2.78

0.00

0.62

No

0.63

No

Computer-Hardware/Equipment

175

79

3.33

3.46

0.00

0.00

No

0.45

No

Computer-Software/Services

372

163

2.66

2.85

0.00

0.00

No

0.55

No

Construction-Heavy/Engineering

362

11

2.14

2.84

0.00

0.53

No

0.73

No

Construction-Residential/Commercial

168

21

2.01

1.34

0.00

0.59

No

0.84

No

Cosmetics/Personal care

24

12

2.09

2.07

0.00

0.00

No

0.50

No

Educational services

15

22

2.35

2.70

0.05

0.77

No

0.21

No

Electric utility

155

59

1.56

0.87

0.00

0.00

No

0.00

Yes

Electrical equipment

238

58

2.63

2.75

0.00

0.00

No

0.34

No

Electronics

430

133

2.96

3.05

0.00

0.00

No

0.31

No

Entertainment

42

39

2.86

2.71

0.00

0.00

No

0.29

No

Environmental

39

37

2.79

2.81

0.00

0.03

No

0.13

Yes

Financial services-Brokerage/Investment banking

94

21

1.87

2.58

0.00

0.00

No

0.09

Yes

Financial services-Diversified

79

103

1.13

2.40

0.00

0.00

No

0.00

Yes

Food-Processing

271

74

1.70

1.79

0.00

0.00

No

0.48

No

Food-Retail/Supermarkets

25

12

1.81

1.70

0.00

0.25

No

0.81

No

Food-Wholesalers

15

13

2.08

1.55

0.05

0.02

No

0.09

Yes

Furniture/Home decoration

71

26

2.37

2.87

0.00

0.00

No

0.49

No

Hotel/Casino

153

41

1.91

2.44

0.00

0.57

No

0.28

No

Household products

66

20

2.17

1.83

0.00

0.05

No

0.42

No

Exhibit 3 continued

Unlevered Total Betas

 

Tests of Normality:

 

Test of the Difference of Medians: Significances

 

Shapiro-Wilk Significance

Industry

N EM

N US

Total

Total

EM Total Betas

US Total Betas

Both

W-W Test

Medians

 

Beta EM

Beta US

normal?

different?

Industrial services

169

99

2.12

2.34

0.00

0.00

No

0.22

No

Information services

15

17

1.75

2.18

0.00

0.30

No

0.98

No

Internet

86

80

2.95

3.33

0.00

0.00

No

0.08

Yes

Machinery

251

92

2.42

2.42

0.00

0.00

No

0.46

No

Maritime transportation

112

34

1.72

1.13

0.00

0.00

No

0.49

No

Medical services

49

89

1.45

2.47

0.00

0.00

No

0.01

Yes

Medical supplies

45

157

2.29

2.91

0.00

0.00

No

0.27

No

Metal fabricating

42

20

1.65

2.50

0.00

0.53

No

0.18

No

Mining

156

52

2.78

3.47

0.00

0.00

No

0.01

Yes

Natural gas

48

68

1.28

1.05

0.00

0.00

No

0.40

No

Office Equipment/Supplies

27

15

2.14

2.27

0.00

0.42

No

0.86

No

Oilfield services/equipment

100

83

2.07

2.59

0.00

0.00

No

0.06

Yes

Oil-Integrated

18

24

1.95

2.01

0.04

0.31

No

0.49

No

Oil-Producing

32

93

2.21

2.77

0.00

0.00

No

0.35

No

Packaging/Container

77

20

1.69

1.90

0.00

0.69

No

0.00

Yes

Paper/Forest products

98

26

1.68

1.90

0.00

0.38

No

0.20

No

Pharmaceuticals

199

144

2.25

3.46

0.00

0.00

No

0.74

No

Pharmacy services

20

10

2.27

1.92

0.00

0.02

No

0.36

No

Prin