Title: Bernard Dumas Fin 748 248 Fin 749 249 Market Equilibrium, Cost of Capital and International Acquisit
1Fall 2008
International Finance Faculty Professor Bernard
Dumas The International Cost of Equity Capital
data availability problem
2Overview
- 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.
3Data availability problems
4Transposing 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.
5In 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
6How good an approximation is that?
7How good an approximation?
8Other 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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10The dimensions of risk in the world
- those that investors care about
- the building blocks that characterize an asset
11The 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
12The 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 ...)
13Conclusion
- Use the various dimensions of risk like building
blocks. - Price each building block
- Sum them