what are international investments?
all those operations that over time generate flows denominated in foreign currency and/or placed in countries other than the investor’s country
how do international investments influence value?
FOREIGN currency influences value through the EXCHANGE RATE
PLACEMENT in a foreign country influences value through the COST OF CAPITAL
international investments NPV formula
slide 3
what are the relevant variables for the evaluation of international projects?
- initial investment in $ converted into euro
- GROSS operating FCFO
- foreign tax rate
- tax rate for the transfer of cashflows from one country to another
!!! in most countries, transferring cashflows to the country of origin is subject to a tax levy - foreign risk free rate
- Risk premium of the investment evaluated on the market of Country $ and “re-parameterized” to the country of origin of the investor
- ER
how to transform cashflows from dollars to euros?
what is the best method?
A
1. discount flows in $ at their $ cost of capital and then convert with the ER
- convert each year’s $ flow into euros with the forward rate, then discount at the euro cost of capital
B
method 1
when evaluating a risky investment, since it is necessary to associate the risk-free interest rate with a risk premium linked to the country in which the investment is made in order to build a specific cost of capital, the most correct method of evaluation is to discount the flows at the cost of capital of the investment country at time 0 and convert the value at the exchange rate at time 0
covered interest rate parity
The equilibrium condition on the market in the investment between different countries tells us that the final value of the investment in $ (denominated in €) must be equal to the final value of the investment in €.
when isn’t it necessary to estimate country risk?
- the marginal investor is GLOBALLY diversified
- the country risk is SPECIFIC, and therefore DIVERSIFIABLE
two approaches for measuring country risk
- analytical method: ratings
- market based methodS
EXTRA
a. sovereign default SPREAD (difference in interest rates, considering the same maturity, between one country and another of zero/low default risk)
!!!! to obtain the risk measure BOTH bonds have to be denominated in the SAME CURRENCY
b. CDS: protection in exchange for a periodic payment of a % (swap) to the seller. In the event of default, renegotiation or events that change the value of the underlying bond, the CDS seller is obliged to repay the NOMINAL value of the bond to the buyer OR to pay the DIFFERENCE between the NOMINAL value and the REDUCED value.
find 5/10 year CDS for the country > subtract the CDS for the benchmark country and you have the value of the spread
issues with CDS
- potential illiquidity
- even if price falls a lot, mechanism is not activated unless there is actual DEFAULT
- guarantee depends on the standing solvency of the guarantor
which comparables to use?
“local” of the target
what is the data from which one should compute beta equity? and beta asset?
local comparables and reference to a local market index
HOWEVER, if we assume an ITA investor owns an ideally DIVERSIFIED ITALIAN PORTFOLIO (domestic), the value of beta must be corrected through FMB (foreign market beta)
formula
FMB exercise
slide 28
how do you proceed if there are no local comparables?
!both are sub-optimal
- Calculate the sector beta (on the local market, Foreign) of a sector that in the domestic market (ITA) is similar to the sector of the investment from the point of view of correlation with respect to the market (the similarity must also be verified on other markets). For example, use, for the valuation of a chemical company, the beta of the metal production sector if in the domestic market (Italy) metal production sector and chemical sector have a similar beta.
- Use the beta of the sector in the domestic market (Italy). For example, use the beta of the metal production sector in Italy, compared to the Italian market. However, many variable would be domestic and the value distorted.
what is the relevant market portfolio and what is the beta to use?
the beta to be used is the “local” (of the DESTINATION COUNTRY) beta.
!!!! however
since the risk is evaluated by an investor in Italy who owns (or should own) a perfectly diversified portfolio on the Italian (domestic) market, the “relevant portfolio” of the investor must be the one of “origin” of the investment.
the beta to be USED is the LOCAL beta CORRECTED for the FMB
should the MRP be local or domestic?
local
should country risk be incorporated in the cost of capital?
it is already incorporate in the difference of risk free rates, HOWEVER, i_rf ONLY incorporates DEFAULT RISK.
ADDITIONAL risk premiums (difficulty in converting currency, capital controls, expropriation…) can be used.
