Bernard Dumas Fin 748 248 Fin 749 249 Market Equilibrium, Cost of Capital and International Acquisit

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Fall 2008
International Finance Faculty Professor Bernard
Dumas The International Cost of Equity Capital
data availability problem
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Overview 

• Data availability problems
• The dimensions of risk in the world
• Note table numbers refer to the numbering in the
  classnote that has been distributed. The same
  numbering is used across several lectures.

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Data availability problems
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Transposing required returns from one country to
another

• In many situations encountered in practice, the
  exposure measurements that are required for the
  application of the various CAPMs are not
  possible.
• For instance, a U.S. automobile manufacturer
  wants to build a plant in Brazil. As usual, it is
  not possible to obtain directly the ?s of the
  project.
• The usual escape is to find an automobile firm
  operating in Brazil that would be comparable to
  the project
• (in practice, you need several comparables for
  statistical reliability)
• But there may not exist such firms.
• It is then necessary to measure stock-return
  relationships in one country (for instance, the
  U.S.), and then transpose them to another country
  (Brazil).
• This guesswork can be aided by a number of
  approximation methods, each one suggested by the
  form of a CAPM.

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In the classic world CAPM, an approximate way to
measure an assets ? vis-à-vis the world

• Lessard Multiply assets exposure (?) to country
  market risk with exposure (?) of country to the
  world market
• 1.0654?0.9751 1.0389
• Why do that?
• In some countries, first number is unmeasured
  (lack of comparable firm)
• One would replace it with ? of comparable firm
  (or of industry) measured in another country

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How good an approximation is that?
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How good an approximation?
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Other approach based on multi-factor CAPM

• If a U.S. automobile manufacturer wants to build
  a plant in Brazil,
• and there is no automobile firm in Brazil
• Take into account the exposures (i.e., multiple
  ?s) from those of the U.S. automobile
  manufacturer (this is where risk decomposition
  comes in)
• Exposure to world risk
• Exposure to Brazil risk (replacing exposure to
  U.S. risk)
• Exposure to automobile industry risk
• Include three risk premia, one for each of these
  risks
• Example Thalès seen as a combination of France
  risk and world risk
• Here, we use factors as building blocks (risk
  decomposition), not as a way to reflect
  shareholder portfolio benchmarks.

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The dimensions of risk in the world

• those that investors care about
• the building blocks that characterize an asset

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The dimensions of risk that investors care about
(and are priced factors see CAPM lectures)

• Represent your shareholders attitude
• World stock market price risk
• Reference asset (i.e., where do we read the risk
  premium?)
• worldwide stock market excess returns,
• Country stock market price risk
• Reference asset each countrys stock market
  excess returns
• Exchange risk (because different shareholders
  live in different monetary zones)
• These are the factors that matter for the pricing
  of risk (the risks that are priced by
  investors, i.e., that make up your firms
  benchmark portfolio)
• The world equity market portfolio
• Own country equity market portfolio (of
  shareholders)
• Currencies

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The dimensions of risk that describe/characterize
an asset

• Second (or additional) categorization to
  describe risk dimensions of an asset
• World, country risks
• to capture, for instance, the risk effect of
  world and country business activity but also
• Industry risk
• Reference asset each industrys worldwide stock
  market excess returns
• Political/crisis/default country risk
• Risk that legal financial contracts will not be
  enforced
• Risk of ruin
• Reference asset Brady bonds or sovereign bonds
  returns?
• These are the risk factors that serve to do a
  decomposition/quantification of risk (how much a
  particular venture is exposed to various risks
  such as
• The world equity market portfolio
• The equity market of the country you invest in
• The industry you invest in
• Currencies your asset is exposed to
• Political risk ...)

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Conclusion

• Use the various dimensions of risk like building
  blocks.
• Price each building block
• Sum them