Data Update 4: Country Risk and Currency Questions!

In my last post, I looked at the risk premiums in US markets, and you may have found that focus to be a little parochial, since as an investor, you could invest in Europe, Asia, Africa or Latin America, if you believed that you would receive a better risk-return trade off. For some investors, in countries with investment restrictions, the only investment options are domestic, and US investment options may not be within their reach. In this post, I will address country risk, and how it affects investment decisions not only on the part of individual investors but also of companies, and then look at the currency question, which is often mixed in with country risk, but has a very different set of fundamentals and consequences.

Country Risk

There should be little debate that investing or operating in some countries will expose you to more risk than in other countries, for a number of reasons, ranging from politics to economics to location. As globalization pushes investors and companies to look outside of their domestic markets, they find themselves drawn to some of the riskiest parts of the world because that is where their growth lies. 

Drivers and Determinants

In a post in early August 2019, I laid out in detail the sources of country risk. Specifically, I listed and provided measures of four ingredients:

1. Life Cycle: As companies go through the life cycle, their risk profiles changes with risk dampening as they mature. Countries go through their own version of the life cycle, with developed and more mature markets having more settled risk profiles than emerging economies which are still growing, changing and generally more risky. High growth economies tend to also have higher volatility in growth than low growth economies. 
2. Political Risk: A political structure that is unstable adds to economic risk, by making regulatory and tax law volatile, and adding unpredictable costs to businesses. While there are some investors and businesses that believe autocracies and dictatorships offer more stability than democracies, I would argue for nuance. I believe that autocracies do offer more temporal stability but they are also more exposed to more jarring, discontinuous change. 
3. Legal Risk: Businesses and investments are heavily dependent on legal systems that enforce contracts and ownership rights. Countries with dysfunctional legal systems will create more risk for investors than countries where the legal systems works well and in a timely fashion.
4. Economic Structure: Some countries have more risk exposure simply because they are overly dependent on an industry or commodity for their prosperity, and an industry downturn or a commodity price drop can send their economies into a tailspin. Any businesses that operate in these countries are consequently exposed to this volatility.

The bottom line, if you consider all four of these risks, is that some countries are riskier than others, and it behooves us to factor this risk in, when investing in these countries, either directly as a business or indirectly as an investor in that business.

Measures

If you accept the proposition that some countries are riskier than others, the next step is measuring this country risk and there are three ways you can approach the task:

a. Country Risk Scores: There are services that measure country risk with scores, trying to capture exposure to all of the risks listed above. The scores are subjective judgments and are not quite comparable across services, because each service scales risk differently. The World Bank provides an array of governance indicators (from corruption to political stability) for 214 countries (https://databank.worldbank.org/source/worldwide-governance-indicators#) , whereas Political Risk Services (PRS) measures a composite risk score for each country, with low (high) scores corresponding to high (low) country risk. 

b. Default Risk: The most widely accessible measure of country risk markets in financial markets is country default risk, measured with a sovereign rating by Moody’s, S&P and other ratings agencies for about 140 countries and a market-based measure (Sovereign CDS) for about 72 countries. The picture below provides sovereign ratings and sovereign CDS spreads across the globe at the start of 2020:

Download spreadsheet

c. Equity Risk: While there are some who use the country default spreads as proxies for additional equity risk in countries, I scale up the default spread for the higher risk in equities, using the ratio of volatility in an emerging market equity index to an emerging market bond index to estimate the added risk premium for countries: 

Note that the base premium for a mature equity market at the start of 2020 is set to the implied equity risk premium of 5.20% that we estimated for the S&P 500 at the start of 2020. The picture below shows equity risk premiums, by country, at the start of 2020:

Download spreadsheet

Looking back at these equity risk premiums for countries going back to 1992, and comparing the country ERP at the start of 2020 to my estimates at the start of 2019, you see a significant drop off, reflecting a decline in sovereign default spreads of about 20-25% across default classes in 2019 and a drop in the equity risk, relative to bonds.

Company Risk Exposure to Country Risk

The conventional practice in valuation, which seems to be ascribe to all countries incorporated and listed in a country, the country risk premium for that country, is both sloppy and wrong. A company’s risk comes from where and how it operates its businesses, not where it is incorporated and traded. A German company that manufactures its products in Poland and sells them in China is German only in name and is exposed to Polish and Chinese country risk. One reason that I estimate the equity risk premiums for as many countries as I need them in both valuation and corporate finance, even if every company I analyze is a US company.

Valuing Companies 

If you accept my proposition that to value a company, you have to incorporate the risk of where it does business into the analysis, the equity risk premium that you use for a company should reflect where it operates. The open question is whether it is better to measure operating risk exposure with where a company generates its revenues, where its production is located or a mix of the two. For companies like Coca Cola, where the production costs are a fraction of revenues and moveable, I think it makes sense to use revenues. Using the company’s 2018-19 revenue breakdown, for instance, the equity risk premium for the country is:

For companies where production costs are higher and facilities are less moveable, your weights for countries should at least partially based on production. At the limit, with natural resource companies, the operating exposure should be based upon where it produces those resources. Thus, Aramco’s equity risk premium should be entirely based on Saudi Arabia’s, since it extracts all its oil there, but Royal Dutch’s will reflect its more diverse production base:

Put simply, the exposure to country risk does not come from where a company is incorporated or where it is traded, but from its operations.

Analyzing Projects/Investments

 If equity risk premiums are a critical ingredient for valuation, they are just as important in corporate finance, determining what hurdle rates multinationals should use, when considering projects in foreign markets. With L’Oreal, for instance, a project for expansion in Brazil should carry the equity risk premium for Brazil, whereas a project in India should carry the Indian equity risk premium. The notion of a corporate cost of capital that you use on every project is both absurd and dangerous, and becomes even more so when you are in multiple businesses.

The Currency Effect

When the discussion turns to country risk, it almost always veers off into currency risk, with many conflating the two, in their discussions. While there are conditions where the two are correlated and draw from the same fundamentals, it is good to keep the two risks separate, since how you deal with them can also be very different.

Decoding Currencies: Interest Rates and Exchange Rates

When analyzing currencies, it is very easy to get distracted by experts with macro views, providing their forecasts with absolute certainty, and distractions galore, from governments keeping their currencies stronger or weaker and speculative trading. To get past this noise, I will draw on the intrinsic interest rate equation that I used in my last post to explain why interest rates in the United States have stayed low for the last decade, 

Intrinsic Riskfree Rate = Inflation + Real GDP Growth

That identity can be used to both explain why interest rates vary across currencies as well as variation in exchange rates over time. 

Risk free Rates

If you accept the proposition that the interest rate in a currency is the sum of the expected inflation in that currency and a real interest that stands in for real growth, it follows that risk free rates will vary across currencies. Getting those currency-specific risk rates can range from trivial (looking up a government bond rate) to difficult (where the government bond rate provides a starting point, but needs cleaning up) to complex (where you have to construct a risk free rate out of what seems like thin air).

1. Government Bond Rates

There are a few dozen governments that issue ten-year bonds in their local currencies, and the search for risk free rates starts there. To the extent that these government bonds are liquid and you perceive no default risk in the government, you can use the government bond rate as your risk free rate. It is that rationale that we use to justify using the Swiss Government’s Swiss Franc 10-year rate as the risk free rate in Swiss Francs and the Norwegian government’s ten-year Krone rate as the riskfree rate in Krone. It is still the rationale, though you are likely to start to get some pushback, in using the US treasury bond rate as the risk free rate in dollars and the German 10-year Euro as the risk free rate in Euros. The pushback will come from some who argue that the US treasury can choose to default and that the German government does not really control the printing of the Euro and could default as well. While I can defend the practice of using the government bond rate as the risk free rate in these scenarios, arguing that you can use the Nigerian government’s Naira bond rate or the Brazilian government’s Reai bond rate as risk free is much more difficult to do. In fact, these are government’s where ratings agencies perceive significant risk even in the local currency bonds and attach ratings that reflect that risk. Moody’s rates Brazil’s local currency bonds at Ba2 and India’s local currency bonds at Baa2. In my pursuit of a risk free rate in currencies like these (where there is no Aaa-rated entity issung a bond), I compute a risk free rate by netting out the default spread:

• Riskfree Rate in currency = Government bond rate – Default Spread for sovereign local-currency rating

Using this approach on the Indian rupee and the Brazilian reai,

• Riskfree Rate in Rupees on January 1, 2020 = Indian Government Rupee Bond rate on January 1, 2020 – Default spread based on Baa2 rating = 6.56% - 1.59% = 4.95%
• Riskfree Rate in Brazilian $R = Brazilian Government $R Bond rate on January 1, 2020 – Default spread based on Ba2 rating = 6.77% - 2.51% = 4.26%

Extending this approach to all countries where a local currency government bond is available, we get the following risk free rates:

Download spreadsheet

Note that these estimates are only as good as the three data inputs that go into them. First, the government bond rates reported have to reflect a traded and liquid bond, clearly not an issue with the US treasury or German Euro bond, but a stretch for the Zambian kwacha bond. Second, the local currency rating is a good measure of the default risk, a challenge when ratings agencies are biased or late in adjusting. Third, the default spread, given the ratings class, is estimated without bias and reflects the market at the time of the assessment. 

2. Synthetic Risk free Rates

If you have doubts about one or more of three assumptions needed to use the government-bond approach to getting to risk free rates, don’t fear, because there is an alternative that I will call my synthetic risk free rate. To use this approach, let’s start with a currency in which you feel comfortable estimating a risk free rate, say the US dollar. If the key driver of risk free rates is expected inflation, the risk free rate in any other currency can be estimated using the differential inflation between that currency and the US dollar. In the short cut, you add the differential inflation to the US T.Bond rate to get a risk free rate:
 Local Currency Risk free rate = US T.Bond Rate + (Inflation rate in local currency - Inflation rate in US dollars)
In the full calculation, you incorporate the compounding effects of the differential inflation

This approach can be used in almost any setting to estimate a local currency risk free rate, including the following:

1. Currencies with no government bonds outstanding: There are more than 120 currencies, where there are no government bonds in the local currency; the country borrows from banks and the IMF, not from markets. Without a government bond rate, the approach described above becomes moot.
2. Currencies where the government bond rate is not trustworthy: There are currencies where there is a government bond, with a rate, but an absence of liquidity and/or the presence of institutions being forced to buy the bond by the government that may make the rates untrustworthy. I don't mean to cast aspersions, but I seriously doubt that the Zambian Kwacha bond, whose rate I specified in the last section, has a deep or wide market.
3. Pegged Currencies: There are some currencies that have been pegged to the US dollar, either for convenience (much of the Middle East) or stability (Ecuador). While analysts in these markets often use the US T.Bond rate as the risk free rate, there is a very real danger that what is pegged today may be unpegged in the future, especially when the fundamentals don't support the peg. Specifically, if the local inflation rate is much higher than the inflation rate in the US, it may be more prudent to use the synthetic risk free rate instead of the US T.Bond rate as the risk free rate.

The key inputs here are the expected inflation rate in the US dollar and the expected inflation rate in the local currency. The former can be obtained from market data, using the difference between the US T.Bond rate and the TIPs rate, but the latter is more difficult. While you can always use last year’s inflation rate, but that number is not only backward looking but subject to manipulation. I prefer the forecasts of inflation that you can get from the IMF, and I have used those to get expected risk free rates in other currencies, using the US T.Bond rate as my base risk free rate, and you can find them at this link.

Currency Choice

Having belabored the reasons for why riskfree rates vary across currencies, let’s talk about how to pick a currency to use in valuing a company. The key word is choice, since you can value any company in any currency, though it may be easiest to get financial information on the company, in a local currency. An Indian company can be valued in US dollars, Indian Rupees or Euros, or even in real terms, and if you are consistent about dealing with inflation in your valuation, the value should be the same in every currency. At first sight, that may sound odd, since the risk free rate in US dollars is much lower than the risk free rate in Indian rupees, but the answer lies in looking at all of the inputs into value, not just the discount rate. In fact, inflation affects all of your numbers:

With high inflation currencies, the damage wrought by the higher discount rates that they bring into the process are offset by the higher nominal growth you will have in your cash flows, and the effects will cancel out. With low inflation currencies, any benefits you get from the lower discount rates that come with them will be given back when you use the lower nominal growth rates that go with them. In practice, there is perhaps no other aspect of valuation where you are more likely to be see consistency errors than with currencies, and here are some scenarios:

1. Casual Dollarization: In casual dollarization, you start by estimating your costs of equity and capital in US dollars, partly because you do not want to or cannot estimate risk free rates in a local currency. You then convert your expected future cash flows in the local currency and convert them to dollars using the current exchange rate. That represents a fatal step, since the inflation differentials that cause risk free rates to be different will also cause exchange rates to change over time. Purchasing power parity may be a crude approximation of reality, but it is a reality that will eventually hold, and ignoring can lead to valuation errors that are huge.
2. Corporate hurdle rates: I have long argued against computing a corporate cost of capital and using it as a hurdle rate on investments and acquisitions, and that argument gets even stronger, when the investments or acquisitions are cross-border and in different currencies. If a European company takes its Euro cost of capital and uses it to value Hungarian, Polish or Russian companies, not correcting for either country risk or currency differentials, it will find a lot of “bargains”.
3. Mismatched Currency Frames of Reference: We all have frames of reference that are built into our thinking, based upon where we live and the currencies we deal with. Having lived in the US for 40 years and dealt with more US companies than companies in any other market, I tend to think in US dollar terms, when I think of reasonable, high or low growth rates. While that is understandable, I have to remember that when conversing with an Indian analyst in Mumbai, whose day-to-day dealings in rupees, the growth rates that he or she provides me for a company will be in rupees. Consequently, it behooves both of us to be explicit about currencies (my expected growth rate for Infosys, in US dollars, is 4.5% or my cost of capital, in Indian rupees, is 10%) when making statements, even though it is cumbersome.

One of the side costs of globalization is that you can no longer assume, especially if you are a US investor or analysts, that the conversations that you will be having will always be on your currency terms (presumably dollars). Understanding how currencies are measurement tools, not instruments of risk or asset classes, will make that transition easier.

Conclusion

In this post,  I looked at two variables, country and currency, that are often conflated in valuation, perhaps because risky countries tend to have volatile currencies, and separated the discussion to examine the determinants of each, and why they should not be lumped together. I can invest in a company in a risky country, and I can choose to do the valuation in US dollars, but only if I recognize that the currency choice cannot make the country risk go away. In other words, a Russian or Brazilian company will stay risky, even if you value it in US dollars, and a company that gets all of its revenues in Northern Europe will stay safe, even if you value it in Russian Rubles.

YouTube Video


Data Links

1. Ratings and Sovereign CDS spreads, by country (January 2020)
2. Country Equity Risk Premiums in January 2020
3. Government Bond Rates and Riskfree Rates by Currency in January 2020
4. Synthetic Riskfree Rates in 2020 (with inflation rates by currency)

Data Update Posts

1. Data Update 1 for 2020: Setting the Table
2. Data Update 2 for 2020: Retrospective on a Disruptive Decade
3. Data Update 3 for 2020: The Price of Risk!
4. Data Update 4 for 2020: Country and Currency Effects

January 2019 Data Update 5: Hurdle Rates and Costs of Financing

In the last post, I looked at how to measure risk from different perspectives, with the intent of bringing these risk measures into both corporate finance and valuation. In this post, I will close the circle by converting risk measures into hurdle rates, critical in corporate finance, since they drive whether companies should invest or not, and in valuation, because they determine the values of businesses. As with my other data posts, the focus will remain on what these hurdle rates look like for companies around the world at the start of 2019.

A Quick Introduction

The simplest way to introduce hurdle rates is to look at them from the perspectives of the capital providers to a business. Using a financial balance sheet as my construct, here is a big picture view of these costs:

Thus. the hurdle rate for equity investors, i.e., the cost of equity, is the rate that they need to make, to break even, given the risk that they perceive in their equity investments. Lenders, on the other hand, incorporate their concerns about default risk into the interest rates they set on leans, i.e., the cost of debt. From the perspective of a business that raises funds from both equity investors and lenders, it is a weighted average of what equity investors need to make and what lenders demand as interest rates on borrowing, that represents the overall cost of funding, i.e., the cost of capital.

I have described the cost of capital as the Swiss Army Knife of finance, used in many different contexts and with very different meanings. I have reproduced below the different uses in a picture:

Paper on cost of capital

It is precisely because the cost of capital is used in so many different places that it is also one of the most misunderstood and misused numbers in finance. The best way to reconcile the different perspectives is to remember that the cost of capital is ultimately determined by the risk of the enterprise raising the funding, and that all of the many risks that a firm faces have to find their way into it. I have always found it easiest to break the cost of capital into parts, and let each part convey a specific risk, since if I am careless, I end up missing or double counting risk. In this post, I will break the risks that a company faces into four groups: the business or businesses the company operates in (business risk), the geographies that it operates in (country risk), how much it has chosen to borrow (financial leverage risk) and the currencies its cash flows are in (currency effects). 

Note that each part of the cost of capital has a key risk embedded in it. Thus, when valuing a company, in US dollars, in a safe business in a risky country, with very little financial leverage, you will see the 10-year US treasury bond rate as my risk free rate, a low beta (reflecting the safety of the business and low debt), but a high equity risk premium (reflecting the risk of the country).  The rest of this post will look at each of the outlined risks.

I. Business Risk
In my last post, where I updated risk measures across the world, I also looked at how these measures varied across different industries/businesses. In particular, I highlighted the ten most risky and safest industries, based upon both price variability and earnings variability, and noted the overlap between the two measures. I also looked at how the perceived risk in a business can change, depending upon investor diversification, and captured this effect with the correlation with the overall market.  If you are diversified, I argued that you would measure the risk in an investment with the covariance of that investment with the market, or in its standardized form, its beta.

To get the beta for a company, then, you can adopt one of two approaches.

• The first, and the one that is taught in every finance class, is to run a regression of returns on the stock against a market index and to use the regression beta. 
• The second, and my preferred approach, is to estimate a beta by looking at the business or businesses a company operates in, and taking a weighted average of the betas of companies in that business. 

To use the second approach, you need betas by business, and each year, I estimate these numbers by averaging the betas of publicly traded companies in each business. These betas, in addition to reflecting the risk of the business, also reflect the financial leverage of companies in that business (with more debt pushing up betas) and their holdings in cash and marketable securities (which, being close to risk less, push down betas). Consequently, I adjust the average beta for both variables to estimate what is called a pure play or a business beta for each business. (Rather than bore you with the mechanics, please watch this video on how I make these adjustments). The resulting estimates are shown at this link, for US companies. (You can also download the spreadsheets that contain the estimates for other parts of the world, as well as global averages, by going to the end of this post).

To get from these business betas to the beta of a company, you need to first identify what businesses the company operates in, and then how much value it derives from each of the businesses. The first part is usually simple to do, though you may face the challenge of finding the right bucket to put a business into, but the second part is usually difficult, because the individual businesses do not trade. You can use revenues or operating income by business as approximations to estimate weights or apply multiples to each of these variables (by looking at what other companies in the business trade at) to arrive at value weights. 

II. Financial Leverage

You can run a company, without ever using debt financing, or you can choose to borrow money to finance operations. In some cases, your lack of access to new equity may force you to borrow money and, in others, you may borrow money because you believe it will lower your cost of capital. In general, the choice of whether you use debt or equity remains one of the key parts of corporate finance, and I will discuss it in one of my upcoming data posts. In this post, though, I will just posit that your cost of capital can be affected by how much you borrow, unless you live in a world where there are no taxes, default risk or agency problems, in which case your cost of capital will remain unchanged as your funding mix changes.  If you do borrow money to fund some or a significant portion of your operations, there are three numbers that you need to estimate for your cost of capital:

1. Debt Ratio: Th mix of debt and equity that you use represents the weights in your cost of capital.
2. Beta Effect: As you borrow money, your equity will become riskier, because it is a residual claim, and having more interest expenses will make that claim more volatile. If you use beta as your measure of risk, this will require you to adjust upwards the business (or unlettered) beta that you obtained in the last part, using the debt to equity ratio of the company. 
   
3. Cost of Debt: The cost of debt, which is set by lenders based upon how much default risk that they see in a company, will enter the cost of capital equation, with an added twist. To the extent that the tax law is tilted towards debt, the after-tax cost of borrowing will reflect that tax benefit. Since this cost of debt is a cost of borrowing money, long term and today, you cannot use a book interest rate or the interest rate on existing debt. Instead, you have to estimate a default spread for the company, based upon either its bond ratings or financial ratios, and add that spread on to the risk free rate:
   

I look at the debt effect on the cost of capital in each of the industries that I follow, with all three effects incorporated in this link, for US companies. The data, broken down, by other regional sub-groupings is available at the end of this post.

III. Country Risk
It strikes me as common sense that operating in some countries will expose you to more risk than operating in others, and that the cost of capital (hurdle rate) you use should reflect that additional risk. While there are some who are resistant to this proposition, making the argument that country risk can be diversified by having a global portfolio, that argument is undercut by rising correlations across markets. Consequently, the question becomes not whether you should incorporate country risk, but how best to do it. There are three broad choices:

1. Sovereign Ratings and Default Spreads: The vast majority of countries have sovereign ratings, measuring their default risk, and since these ratings go with default spreads, there are many who use these default spreads as measures of country risk. 
2. Sovereign CDS spreads: The Credit Default Swap (CDS) market is one where you can buy insurance against sovereign default, and it offers a market-based estimate of sovereign risk. While the coverage is less than what you get from sovereign ratings, the number of countries where you can obtain these spreads has increased over time to reach 71 in 2019. 
3. Country Risk Premiums: I start with the default spreads, but I add a scaling factor to reflect the reality that equities are riskier than government bonds to come up with country risk premiums. The scaling factor that I use is obtained by dividing the volatility of an emerging market equity index by the volatility of emerging market bonds. 

To incorporate the country risk into my cost of capital calculations, I start with the implied equity risk premium that I estimated for the US (see my first data post for 2019) or 5.96% and add to it the country risk premium for each country. The full adjustment process is described in this picture:

I also bring in frontier markets, which have no sovereign ratings, using a country risk score estimated by Political Risk Services. The final estimates of equity risk premiums around the world can be seen in the picture below:

You can see these equity risk premiums as a list by clicking here, or download the entire spreadsheet here. If you prefer a picture of equity risk around the world, my map is below:

Download spreadsheet

I also report regional equity risk premiums, computed by taking GDP-weighted averages of the equity risk premiums of the countries int he region.

IV. Currency Risk
It is natural to mix up countries and currencies, when you do your analysis, because the countries with the most risk often have the most volatile currencies. That said, my suggestion is that you keep it simple, when it comes to currencies, recognizing that they are scaling or measurement variables rather than fundamental risk drivers. Put differently, you can choose to value a Brazilian companies in US dollars, but doing so does not make Brazilian country risk go away.

So, why do currencies matter? It is because each one has different expectations of inflation embedded in it, and when using a currency, you have to remain inflation-consistent. In other words, if you decide to do your analysis in a high inflation currency, your discount rate has to be higher, to incorporate the higher inflation, and so do your cash flows, for the same reason:

There are two ways in which you can bring inflation into discount rates.  The first is to use the risk free rate in that currency as your starting point for the calculation, since risk free rates will be higher for high inflation currencies. The challenge is finding a risk free investment in many emerging market currencies, since even the governments bonds, in those currencies, have default risk embedded in them. I attempt to overcome this problem by starting with the government bond but then netting the default spread for the government in question from that bond to arrive at risk free rates:

Download raw data

These rates are only as reliable as the government bond rates that you start with, and since more than two thirds of all currencies don't even have government bonds and even on those that do, the government bond rate does not come from liquid markets, there a second approach that you can use to adjust for currencies. In this approach, you estimate the cost of capital in a currency that you feel comfortable with (in terms of estimating risk free rates and risk premiums) and then add on or incorporate the differential inflation between that currency and the local currency that you want to convert the cost of capital to. Thus, to convert the cost of capital in US $ terms to a different currency, you would do the following:

To illustrate, assume that you have a US dollar cost of capital of 12% for an Egyptian company and that the inflation rates are 15% and 2% in Egyptian Pounds and US dollars respectively:

The Egyptian pound cost of capital is 26.27%. Note that there is an approximation that is often used, where the differential inflation is added to the US dollar cost of capital; in this case your answer would have been 25%. The key to this approach is getting estimates of expected inflation, and while every source will come with warts, you can find the IMF's estimates of expected inflation in different currencies at this link.

General Propositions
Every company, small or large, has a hurdle rate, though the origins of the number are murky at most companies. The approach laid out in this post has implications for how hurdle rates get calculated and used.

1. A hurdle rate for an investment should be more a reflection the risk in the investment, and less your cost of raising funding: I fault terminology for this, but most people, when asked what a cost of capital is, will respond with the answer that it is the cost of raising capital. In the context of its usage as a hurdle rate, that is not true. It is an opportunity cost, a rate of return that you (as a company or investor) can earn on other investments in the market of equivalent risk. That is why, when valuing a target firm in an acquisition, you should always use the risk characteristics of the target firm (its beta and debt capacity) to compute a cost of capital, rather than the cost of capital of the acquiring firm.
2. A company-wide hurdle rate can be misleading and dangerous: In corporate finance, the hurdle rate becomes the number to beat, when you do investment analysis. A project that earns more than the hurdle rate becomes an acceptable one, whether you use cash flows (and compute a positive net present value) or income (and generate a return greater than the hurdle rate). Most companies claim to have a corporate hurdle rate, a number that all projects that are assessed within the company get measured against. If your company operates in only one business and one country, this may work, but to the extent that companies operate in many businesses across multiple countries, you can already see that there can be no one hurdle rate. Even if you use only one currency in analysis, your cost of capital will be a function of which business a project is in, and what country it is aimed at. The consequences of not making these differential adjustments will be that your safe businesses will end up subsidizing your risky businesses, and over time, both will be hurt, in what I term the "curse of the lazy conglomerate".
3. Currency is a choice, but once chosen, should not change the outcome of your analysis: We spend far too much time, in my view, debating what currency to do an analysis in, and too little time working through the implications. If you follow the consistency rule on currency, incorporating inflation into both cash flows and discount rates, your analyses should be currency neutral. In other words, a project that looks like it is a bad project, when the analysis is done in US dollar terms, cannot become a good project, just because you decide to do the analysis in Indian rupees. I know that, in practice, you do get divergent answers with different currencies, but when you do, it is because there are inflation inconsistencies in your assessments of discount rates and cash flows.
4. You cannot (and should not) insulate your cost of capital from market forces: In both corporate finance and investing, there are many who remain wary of financial markets and their capacity to be irrational and volatile. Consequently, they try to generate hurdle rates that are unaffected by market movements, a futile and dangerous exercise, because we have to be price takers on at least some of the inputs into hurdle rates. Take the risk free rate, for instance. For the last decade, there are many analysts who have replaced the actual risk free rate (US 10-year T.Bond rate, for instance) with a "normalized' higher number, using the logic that interest rates are too low and will go up. Holding all else constant, this will push up hurdle rates and make it less likely that you will invest (either as an investor or as a company), but to what end? That uninvested money cannot be invested at the normalized rate, since it is fictional and exists only in the minds of those who created it, but is invested instead at the "too low" rate. 
5. Have perspective: In conjunction with the prior point, there seems to be a view in some companies and for some investors, that they can use whatever number they feel comfortable with as hurdle rates. To the extent that hurdle rates are opportunity costs in the market, this is not true. The cost of capital brings together all of the risks that we have listed in this section. If nothing else, to get perspective on what comprises high or low, when it comes to cost of capital, I have computed a histogram of global and US company costs of capital, in US $ terms.
   
   
   You can convert this table into any currency you want. The bottom line is that, at least at the start of 2019, a dollar cost of capital of 14% or 15% is an extremely high number for any publicly traded company. You can see the costs of capital, in dollar terms, for US companies at this link, and as with betas, you can download the cost of capital, by industry, for other parts of the world in the data links below this post.

In short, if you work at a company, and you are given a hurdle rate to use, it behooves you to ask questions about its origins and logic. Often, you will find that no one really seems to know and/or the logic is questionable.

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Data Sets

1. Betas by Business: US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada
2. Sovereign Ratings and CDS Spreads by Country in January 2019
3. Equity Risk Premiums by Country in January 2019
4. Risk free Rates by Currency: Government bond based
5. Cost of Capital in US $ (with conversion equation for other currencies): US, Global, Emerging Markets, Europe, Japan, India, China, Aus & Canada

January 2019 Data Updates

1. Data Update 1: A Reminder that equities are risky, in case you forgot!
2. Data Update 2: The Message from Bond Markets
3. Data Update 3: Playing the Numbers Game
4. Data Update 4: The Many Faces of Risk
5. Data Update 5: Of Hurdle Rates and Funding Costs!
6. Data Update 6: Profitability and Value Creation!
7. Data Update 7: Debt, neither poison nor nectar!
8. Data Update 8: Dividends and Buybacks - Fact and Fiction!
9. Data Update 9: Playing the Pricing Game!

Decoding Currency Risk: Pictures of Global Risk - Part IV

In my last three posts, I have looked at country risk, starting with measures of that risk and then moving on to valuing and pricing that risk. You may find it strange that I have not mentioned currency risk in any of these posts on country risk, but in this one, I hope to finish this series by looking first at how currency choices affect value and then at the dynamics of currency risk.  

Currency Consistency

A fundamental tenet in valuation is that you have to match the currency in which you estimate your cash flows with the currency that you estimate the discount rate that you use to discount those cash flows. Stripped down to basics, the only reason that the currency in which you choose to do your analysis matters is that different currencies have different expected inflation rates embedded in them. Those differences in expected inflation affect both our estimates of expected cash flows and discount rates. When working with a high inflation currency, we should therefore expect to see higher discount rates and higher cash flows and with a lower inflation currency, both discount rates and cash flows will be lower. In fact, we could choose to remove inflation entirely out of the process by using real cash flows and a real discount rate. 

Currencies and Discount Rates

There are two ways in which you can incorporate the expected inflation in a currency into the discount rate that you estimate in that currency. The first is through the risk free rate that you use for the currency, since higher expected inflation should result in a higher risk free rate. The second is by converting the discount rate that you estimate in a base currency into a discount rate in an alternate currency, using the differential inflation between the currencies.

a. Risk free rate

A risk free rate is more than just a number that you look up to estimate discount rates. In a functioning market, investors should set the risk free rate in a currency high enough to cover not only expected inflation in that currency but also to earn a sufficient real interest rate to compensate for deferring consumption.
Risk free rate in a currency = Expected inflation in that currency + Real interest rate
The risk free rate should therefore be higher in a high-inflation currency than using that higher rate should bring inflation into your discount rate.

But how do we get risk free rates in different currencies? While most textbooks would suggest using the rate on a government bond, denominated in the currency in question, that presumes that governments are default free and that the government bond rate is a market-determined rate. However, governments are not always default free (even with local currency borrowings) and the rate may not be market-set. In July 2015, I started with the government bond rates in 42 currencies and cleansed them of default risk by subtracting out the sovereign default spreads (based on local currency sovereign ratings) from them to arrive at risk free rates in these currencies, which you can find in the table below:

Risk free rates in July 2015

Note that the default spread is set to zero for all Aaa rated governments, and the government bond rate becomes the risk free rate in the currency. Thus, the risk free rates in US dollars is 2.47% and in Swiss Francs is 0.16%. To compute the risk free rate in $R (Brazilian Reais), I subtract out my estimate of the default spread for Brazil (1.90%, based on its Baa2 rating) from the government bond rate of 12.58% to arrive at a risk free rate of 10.68%. To estimate a cost of equity in nominal $R for an average risk company with all of its operations in Brazil, you would use the 10.68% risk free rate in $R and the equity risk premium of 8.82% that I reported in my last post to arrive at a cost of equity of 19.50% in $R. That number would be higher for above-average risk companies, with a beta operating as your scaling mechanism.

b. Differential inflation

There are two problems with the risk free rate approach. The first is that it not only requires that you be able to find a government bond rate in the currency that you are working with, but also that the rate be a market-determined number. It remains true that in much of the world, government bond rates are either artificially set by governments or actively manipulated to yield unrealistic values. The second is that you are adding equity risk premiums that are computed in dollar-based markets (since the default spreads that they are built upon are from dollar-based bond or CDS markets) to risk free rates in other currencies. You could legitimately argue that the equity risk premium that you add on to a $R risk free rate of 10.68% should be higher than the 8.82% that you added to a US $ riskfree rate of 2.25% in July 2015.

If the differences between currencies lies in the fact that there are different expectations of inflation embedded in them, you should be able to use that differential inflation to adjust discount rates in one currency to another. Thus, if the cost of capital is computed in US dollars and you intend to convert it into a nominal $R cost of capital, you could do so with the following equation:

To illustrate, if you assume that the expected inflation rate in $R is 9.5% and in US $ is 1.5%, you could compute the cost of equity in US$ and then adjust for the differential inflation to arrive at a cost of equity in $R:

Cost of equity for average risk Brazilian company in US $ = 2.25% + 8.66% = 10.91%

The cost of equity of 19.65% that we derive from this approach is higher than the 19.50% that we obtained from the risk free rate approach and is perhaps a better measure of cost of equity in $R.

This approach rests on being able to estimate expected inflation in different currencies, a task that is easier in some than others. For instance, getting an expected inflation rate in US dollars is simple, since you can use the difference between the 10-year T.Bond rate and the TIPs (inflation-indexed) 10-year bond rate as a proxy. In other currencies, it can be more difficult, and you often only have past inflation rates to go with, numbers that are prone to government meddling and imperfect measurement mechanisms. Notwithstanding these problems, I report inflation rates in different countries, using the average inflation rate from 2010-2014 for each country.

I also report the inflation rate in 2014 and the IMF expectations for inflation (though I remain dubious about their quality) for each country.

Currencies and Cash Flows

Following the currency consistency principle is often easier with discount rates, where your inflation assumptions are generally either explicit or easily monitored, than it is with cash flows, where these same assumptions are implicit or borrowed from others. If you add in accounting efforts to adjust for inflation and inconsistencies in dealing with it to the mix, it should come as no surprise that in many valuations, it is not clear what inflation rate is embedded in the cash flows.

a. Inflation in your growth rates

In most valuations, you start with base year accounting numbers on revenues, earnings and cash flows and then attach growth rates to one or more of these numbers to get to expected cash flows in the future. At the risk of stating the obvious, the expected inflation rate embedded in this growth rate has to be the same inflation rate that you are incorporating in your discount rate. This simple proposition is put to the test, though, by the ways in which we estimate these expected growth rates, which is to use history, trust management/analyst projections for the future or base it on fundamentals (how much the company is reinvesting and how well it is reinvesting):

1. Past Growth: With historical growth, where you estimate growth by looking at the past, your biggest exposure to mismatches occur in currencies where inflation rates have shifted significantly over time. For instance, assume that you are valuing your company in Indian rupees in July 2015 and that the average inflation rate in India, which was 8% between 2010 and 2014 is expected to decline to 4% in the future. If you use historical growth rates in earnings, between 2010 and 2014, for an Indian company, you are likely to over value the company because its past growth rate will reflect past inflation (8%) but your discount rates, computed using expected inflation or current risk free rates in rupees, will reflect a much lower inflation rate. 
2. Management/Analyst Forecasts: With management or analyst forecasts, the problem is a different one, since the expected inflation rates that individuals use in their forecasts can vary widely. While there is no reason to believe that your estimate of expected inflation is better than theirs, it is undeniably inconsistent to use management estimates of expected inflation for growth rates and your own or the market's estimates of inflation, when estimating discount rates.
3. Fundamental or Sustainable Growth: I believe that the best way to keep your valuations internally consistent is to tie growth to how much a company is reinvesting and how well it is reinvesting. The measures we use to measure reinvestment and the quality of investment are accounting numbers and inflation mismatches can enter insidiously into valuations. Assume, for instance, that you are estimating reinvestment rates and returns on capital for a Brazilian company, using its Brazilian financial statements. Since Brazilian accounting allows for inflation adjustments to assets, the return on capital that you compute is closer to a real return on capital (with no or low inflation embedded in it) than to a nominal $R return on capital, if inflation accounting works as advertised. In countries like the United States, where assets are not adjusted for inflation, you can argue that the return on capital is a nominal number, but one that reflects past inflation, not expected future inflation.  In either case, the growth rate that you compute from these numbers will be skewed.

b. Expected Exchange Rates

It is common practice, in some valuation practices, to forecast cash flows in a base currency (even if it is not the currency that you plan to use to estimate your discount rate) and then convert into your desired currency, using expected exchange rates. Thus, a Brazilian analyst who wants to value a Brazilian company in US dollars may estimate expected cash flows in nominal $R first and then convert these cash flow into US $, using an $R/US $ exchange rate.  The big estimation question then becomes how best to estimate expected exchange rates and there are three choices. 

1. Use the currency exchange rate: The first one, especially in the absence of futures or forward markets, is to use the current exchange rate to convert all future cash flows. This will result in an erroneous value for a simple reason: it creates an inflation mismatch. If, for instance, the expected inflation rate in $R in 9.5% and in US$ is 1.5%, you will significantly over value your company with this approach, because you have effectively built into a 9.5% inflation rate into your cash flows (by using a constant exchange rate) and a 1.5% inflation rate into your discount rate (since you are estimating it in US dollars).
2. Use futures and forward market exchange rates: This is more defensible but only if you then extract risk free rates from these same futures/forward market prices. (This will require that you assume interest rate parity in exchange rates and derive the interest rate in $R from the $R/US$ forward rate). In addition, in many emerging market currencies, the forward and futures markets tend to be operational only at the short end of the maturity spectrum, i.e., you can get 1-year forward rates but not 10-year rates.
3. Use purchasing power parity: With purchasing power parity, the expected exchange rates are driven by differential inflation in the currencies in question. Thus, if purchasing power parity holds and the inflation rates are 9.5% in $R and 1.5% in US$, the $R will depreciate roughly 8% every year. While I am sure that you can find substantial evidence of deviation from purchasing power parity for short or even extended periods, here is why I continue to stick with it in valuation. By bringing in the differential inflation into both your cash flows and the discount rate, it cancels out its effect and thus makes it less critical that you get the inflation numbers right. Put differently, you can under or over estimate inflation in $R (or US $) and it will have no effect on your value.

Currencies and Value

If you can make it through the minefields to estimate cash flows and discount rates consistently, i.e., have the same expected inflation rate in both inputs, the value of a company or a capital investment should be currency invariant. In other words, if you value Tata Motors in Indian rupees, you should get the same value for the company, if you value it entirely in US dollars. If you don't get the same value, I would argue that the difference comes from one or two sources:

• Inflation inconsistencies: It is stemming from inconsistencies in the way that you have dealt with inflation in different currencies, since a company's value should come from its fundamentals and not from which currency you chose to evaluate it in. 
• Currency views: You have built in a currency view into your company valuation. Thus, if you assume that the $R will strengthen against the US dollar in the next 5 years,  when estimating cash flows, notwithstanding the higher inflation rate, you will find your company to be under valued, when you value it in $R. If that is the case, my suggestion to you would be to just buy currency futures or options, since you are making a bet on the currency, not the company.

The bottom line is that your currency choice should neither make nor break your valuation. A well-run company that takes good investments should stay valuable, whether I value it in US dollars, Euros, Yen or Rubles, just as a badly run or risky company will have a low value, no matter what currency I value it in.

Currency Risk

When working with cash flows in a foreign currency, it is understandable that analysts worry about currency risk, though their measurement of and prescriptions for that risk are often misplaced. First, it is not the fact that exchange rates change over time that creates risk, it is that they change in unexpected ways. Thus, if the Brazilian Reai depreciates over the next five years in line with the expectations, based upon differential inflation, there is no risk, but if it depreciates less or more, that is risk. Second, even allowing for the fact that there is currency risk in investments in foreign markets, it is not clear that analysts should be adjusting value for that risk, especially if exchange rate risk is diversifiable to investors in the companies making these investments. If this is the case, you are best served forecasting expected cash flows (using expected exchange rates) and not adjusting discount rates for additional currency risk. 

It is true that currency and country risk tend to be correlated and that countries with high country risk also tend to have the most volatile currencies. If so, the discount rates will be higher for investments in these countries but that augmentation is attributable to the country risk, not currency risk.

Currency Rules for the Road

It is easy to get entangled in the web of currency effects and lose sight of your quest for value, but here are few rules that I think may help you avoid distractions.

1. Currencies are measurement mechanisms, not value drivers: As I write this post, it is a hot day in New York, with temperatures hitting 95 degrees in fahrenheit. Restating that temperature as 35 degrees celsius may make it seem cooler (it is after all a lower number) but does not alter the reality that I will be sweating the minute that I step out of my office. In the same vein, if I value an Argentine company in a risky business, converting its cash flows from Argentine pesos to US dollars will not make it less risky or less exposed to Argentine country risk.
2. Pick a currency and stick with it: The good news is that if your valuations are currency invariant, all you have to do is pick one currency (preferably one that you are comfortable with) and stick with it through your entire analysis. 
3. Make your inflation assumptions explicit: While this may cost you some time and effort along the way, it is best to be explicit about what inflation you are assuming, especially when you estimate cash flows or exchange rates, to make sure that it matches the inflation assumptions that you may be building into your discount rates,
4. Separate your currency views from your company valuations: It is perfectly reasonable to have views on currency movements in the future but you should separate your currency views from your company valuations. If you do not, it will be impossible for those using your valuations to  determine whether your judgments about valuation are based upon what you think about the company or what you feel about the currency. It is this separation argument that is my rationale for sticking with much maligned purchasing power parity in estimating future exchange rates.
5. You can run, but you cannot hide: If inflation is high and volatile in your local currency, it is easy to see why you may prefer working with a different, more stable currency. It is the reason why so much valuation and investment analysis in Latin America was done in US dollars. The bad news, though, is that while switching to US dollars may help you avoid dealing with inflation in your discount rate, you will have to deal with it in your cash flows (where you will be called upon to forecast exchange rates). 

Papers to read

1. My paper on country risk (July 2015)

Data attachments

1. Risk free rates in different currencies (July 2015)
2. Inflation rates, by country (July 2015)

Posts on Country Risk

1. Groundhog day in Greece, Hijinks in Brazil and Market Chaos in China: Pictures of Global Risk - Part 1
2. Valuing Country Risk: Pictures of Global Risk - Part II
3. Pricing Country Risk: Pictures of Global Risk - Part III
4. Decoding Currency Risk: Pictures of Global Risk - Part IV