Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation Process*

Most finance textbooks suggest that companies evaluate investment projects using discount rates that reflect both the debt capacity and the unique risks of the project. In practice, however, companies often use their company‐wide WACC to evaluate such investments because of the difficulty of (and subjectivity involved in) estimating the risk of individual projects, and the potential for managerial bias and influence to distort the estimates. This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the “influence costs” that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm‐wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project‐specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating.     

Political risk and international valuation

Measuring the impact of political risk on investment projects is one of the most vexing issues in international business. One popular approach is to assume that the sovereign yield spread captures political risk and to augment the project discount rate by this spread. We show that this approach is flawed. While the sovereign spread is influenced by political risk, it also reflects other risks that are likely included in the valuation analysis — leading to the double counting of risks. We propose to use “political risk spreads” to undo the double counting in the evaluation of international investment projects.     

Valuation in Emerging Markets: A Simulation Approach

Most of the foundations of valuation theory have been designed for use in developed markets. Because of the greater, and in some cases different, risks associated with emerging markets (although recent experience might suggest otherwise), investors and corporate managers are often uncomfortable using traditional methods. The typical way of capturing emerging-market risks is to increase the discount rate in the standard valuation model. But, as the authors argue, such adjustments have the effect of undermining some of the basic assumptions of the CAPM-based discounted cash flow model. The standard theory of capital budgeting suggests that estimates of unconditional expected cash flows should be discounted at CAPM discount rates (or betas) that reflect only “systematic,” or “nondiversifiable,” market-wide risks. In practice, however, analysts tend to take what are really estimates of “conditional” expected cash flows—that is, conditional on the firm or its country avoiding a crisis—and discount them at higher rates that reflect not only systematic risks, but diversifiable risks that typically involve a higher probability of crisis-driven costs of default. But there is almost no basis in theory for the size of the increases in discount rates. In this article, the authors propose that analysts in emerging markets avoid this discount rate problem by using simulation techniques to capture emerging-market risks in their estimates of unconditional expected cash flows—in other words, estimates that directly incorporate the possibility of an emerging-market crisis and its consequences. Having produced such estimates, analysts can then discount them using the standard Global CAPM.     

“一带一路”下防范主权信用评级风险的法律对策研究

“一带一路”战略的实施,凸显主权信用评级的重要价值。然而,主权评级屡次发生风险并演化为系统性风险和危机,造成重大损失。此风险一方面是由主权评级自身在金融稳定时期潜在的风险要素引起的,另一方面也是美欧当下缺乏有效的风险防范措施所导致的。因此,为推进“一带一路”建设,以尽早防范主权评级风险,我国应采取设定“本土+全球”的双评级规范、强化控制和监管国际评级机构以及减弱对主权评级的依赖等法律对策。     

An Empirical Study of International Spillover of Sovereign Risk to Bank Credit Risk

The severity and complexity of the recent financial crisis has motivated the need for understanding the relationships between sovereign ratings and bank credit ratings. This is the first study to examine the impact of the “international” spillover of sovereign risk to bank credit risk through both a ratings channel and an asset holdings channel. In the first case, the downgrade of sovereign ratings in GIIPS (Greece, Italy, Ireland, Portugal, and Spain) countries leads to rating downgrades of banks in the peripheral countries. The second channel indicates that larger asset holdings of GIIPS debt increases the credit risk of cross‐border banks, and hence, the probabilities of downgrade.     

The Role of Real Options in Capital Budgeting: Theory and Practice1

Most discussions of capital budgeting take for granted that discounted cash flow (DCF) and real options valuation (ROV) are very different methods that are meant to be applied in different circumstances. Such discussions also typically assume that DCF is “easy” and ROV is “hard”—or at least dauntingly unfamiliar—and that, mainly for this reason, managers often use DCF and rarely ROV. This paper argues that all three assumptions are wrong or at least seriously misleading. DCF and ROV both assign a present value to risky future cash flows. DCF entails discounting expected future cash flows at the expected return on an asset of comparable risk. ROV uses “risk‐neutral” valuation, which means computing expected cash flows based on “risk‐neutral” probabilities and discounting these flows at the risk‐free rate. Using a series of single‐period examples, the author demonstrates that both methods, when done correctly, should provide the same answer. Moreover, in most ROV applications—those where there is no forward price or “replicating portfolio” of traded assets—a “preliminary” DCF valuation is required to perform the risk‐neutral valuation. So why use ROV at all? In cases where project risk and the discount rates are expected to change over time, the risk‐neutral ROV approach will be easier to implement than DCF (since adjusting cash flow probabilities is more straightforward than adjusting discount rates). The author uses multi‐period examples to illustrate further both the simplicity of ROV and the strong assumptions required for a typical DCF valuation. But the simplicity that results from discounting with risk‐free rates is not the only benefit of using ROV instead of—or together with—traditional DCF. The use of formal ROV techniques may also encourage managers to think more broadly about the flexibility that is (or can be) built into future business decisions, and thus to choose from a different set of possible investments. To the extent that managers who use ROV have effectively adopted a different business model, there is a real and important difference between the two valuation techniques. Consistent with this possibility, much of the evidence from both surveys and academic studies of managerial behavior and market pricing suggests that managers and investors implicitly take account of real options when making investment decisions.     

Enterprise Risk Management: Theory and Practice

The Chief Risk Officer of Nationwide Insurance teams up with a distinguished academic to discuss the benefits and challenges associated with the design and implementation of an enterprise risk management program. The authors begin by arguing that a carefully designed ERM program—one in which all material corporate risks are viewed and managed within a single framework—can be a source of long‐run competitive advantage and value through its effects at both a “macro” or company‐wide level and a “micro” or business‐unit level. At the macro level, ERM enables senior management to identify, measure, and limit to acceptable levels the net exposures faced by the firm. By managing such exposures mainly with the idea of cushioning downside outcomes and protecting the firm's credit rating, ERM helps maintain the firm's access to capital and other resources necessary to implement its strategy and business plan. At the micro level, ERM adds value by ensuring that all material risks are “owned,” and risk‐return tradeoffs carefully evaluated, by operating managers and employees throughout the firm. To this end, business unit managers at Nationwide are required to provide information about major risks associated with all new capital projects—information that can then used by senior management to evaluate the marginal impact of the projects on the firm's total risk. And to encourage operating managers to focus on the risk‐return tradeoffs in their own businesses, Nationwide's periodic performance evaluations of its business units attempt to refl ect their contributions to total risk by assigning risk‐adjusted levels of “imputed” capital on which project managers are expected to earn adequate returns. The second, and by far the larger, part of the article provides an extensive guide to the process and major challenges that arise when implementing ERM, along with an account of Nationwide's approach to dealing with them. Among other issues, the authors discuss how a company should assess its risk “appetite,” measure how much risk it is bearing, and decide which risks to retain and which to transfer to others. Consistent with the principle of comparative advantage it uses to guide such decisions, Nationwide attempts to limit “non‐core” exposures, such as interest rate and equity risk, thereby enlarging the firm's capacity to bear the “information‐intensive, insurance‐ specific” risks at the core of its business and competencies.     

INCORPORATING COUNTRY RISK IN THE VALUATION OF OFFSHORE PROJECTS

Offshore projects, especially those in emerging economies, are generally viewed as more risky, and thus as contributing less to shareholder value, than otherwise comparable domestic investments. Emerging economies are typically more volatile than the economies of industrialized countries. They also present a greater array of risks that are (perceived as being) primarily of a downside nature, such as currency inconvertibility, expropriation, civil unrest, and general institutional instability. Further, because such risks are relatively unfamiliar to the investing companies, the companies are likely to make costly errors in early years and to require more time to bring cash flows and rates of return to acceptable steady-state levels. To reflect these higher risks and greater unfamiliarity, many companies include an extra premium in the discount rate they apply to offshore and, particularly, emerging-market projects. However, the basis for these discount rate adjustments is often arbitrary. Such adjustments do not properly reflect objective information available about either the nature of these risks, or about the ability of management to manage them. Nor do they take into account the reality that the risks stemming from unfamiliarity fall over time as the firm progresses along the learning curve. As a result, companies often “over discount” project cash flows in compensating for these risks, and thus unduly penalize offshore projects. More important, adjusting for country risk using arbitrary adjustments to the discount rate fails to focus management's attention on strategic and financial actions can be taken to reduce risk—notably, actions capable of transferring some of the company's exposures to specific risks to different parties with comparative advantages in bearing those risks. This paper outlines a four-step procedure for assessing overseas risks that integrates these various aspects:

• ? Classify risks in terms of various stakeholders' comparative advantage in risk-taking based on their: (a) existing portfolio of assets; (b) access to information; and (c) capabilities for reducing risk.
• ? Allocate risk through project structuring and financial engineering to exploitthese comparative advantages.
• ? Adjust resulting cash flows (relative to their most-likely levels) for (a) the impact of “asymmetric” risks; (b) learning effects; and (c) potential competitive options and/or barriers to entry resulting from comparative advantage in dealing with risks.
• ? Discount resulting expected cash flows at a risk-adjusted discount rate that reflects the covariance of the cash flows with the benchmark portfolio.

     

USING DISCOUNTED CASH FLOW ANALYSIS IN AN INTERNATIONAL SETTING: A SURVEY OF ISSUES IN MODELING THE COST OF CAPITAL

Based on the results of a recent survey of University of Chicago Graduate School of Business alumni, the authors of this article suggest that prevailing corporate practice in valuing overseas investments reflects a flawed understanding of finance theory. Although the survey finds that almost all respondents use the discounted cash flow (DCF) method in some fashion or another, there is significant variation both in the application of DCF and in the weighting that different groups assign to DCF in dealing with segmented markets. Of greater interest, the survey also shows that, as the complexity and uncertainty involved in valuation tasks increases, practitioners appear to place greater reliance on heuristics, or conventional rules of thumb. And in relying on heuristics as perceived risk increases, the authors warn, “people tend to become less consistent, less systematic, and less rigorous in the methods they use to measure and evaluate risk.” Also of interest to the authors, many practitioners doing international valuations appear to be unwitting adherents to a “multi-factor” asset pricing model. For, in addition to traditional market factor proxies, they tend to incorporate country-specific risks, such as political and sovereign risk, into the discount rate. The authors attribute this practice to the implicit (and generally mistaken) assumption that there is a significant relationship between systematic risk and the degree of foreign market segmentation. Following presentation of their survey results, the authors explore several important issues surrounding international cost of capital. Perhaps most important is the degree of market “segmentation” and how it affects the pricing model (whether a global or a local version of the CAPM, for example) used to calculate the cost of capital. The article provides a framework to help practitioners decide which pricing model is appropriate for valuing a given investment. Moreover, since the cost of capital affects EVA-type measures of operating performance that are often used in performance evaluation schemes, the framework also can be used to guide senior management in thinking about the proper hurdle rates for their overseas business units.     

The network structure of the CDS market and its determinants

This paper analyses the network structure of the credit default swap (CDS) market and its determinants, using a unique dataset of bilateral notional exposures on 642 financial and sovereign reference entities. We find that the CDS network is centred around 14 major dealers, exhibits a “small world” structure and a scale-free degree distribution. A large share of investors are net CDS buyers, implying that total credit risk exposure is fairly concentrated. Consistent with the theoretical literature on the use of CDS, the debt volume outstanding and its structure (maturity and collateralization), the CDS spread volatility and market beta, as well as the type (sovereign/financial) of the underlying bond are statistically significantly related—with expected signs—to structural characteristics of the CDS market.     

The anatomy of sovereign risk contagion

The channels for the cross-border propagation of sovereign risk in the international sovereign debt market are analysed. Identifying sovereign credit events as extraordinary jumps in CDS spreads, we distinguish between the immediate effects of such events and their longer term spillover effects. To analyse “fast and furious” contagion, we use daily CDS data to conduct event studies around a total of 89 identified credit events in a global country sample. To analyse “slow-burn” spillover effects, we apply a multifactor risk model, distinguishing between global and regional risk factors. We find that “fast and furious” contagion has been primarily a regional phenomenon, whilst “slow-burn” spillover effects can often be global in scope, especially those of the recent European debt crisis. The global risk factors are found to be driven by investor risk appetites and debt levels, whilst the regional factors depend on economic fundamentals of countries within a region.     

Factor decomposition of the Eurozone sovereign CDS spreads

In the present study, we examine the factors driving Eurozone sovereign credit default swap (CDS) spreads during the Eurozone sovereign debt crisis. For identifying factors we utilize independent component analysis (ICA), a technique similar to principal component analysis (PCA). We identify three factors that impact spreads and capture the features specific to the crisis such as the breakup risk of the Eurozone: peripheral factor, global factor, and Eurozone common factor. In contrast, when PCA is applied, only a single factor is identified. Moreover, using ICA with a GARCH model, we show that the source of volatility for CDS spreads shifted from the global factor in 2009 and the peripheral factor in 2010 to the Eurozone common factor in 2012, and that the dynamic correlation reflects the decoupling between low credit risk countries such as Germany and high credit risk countries such as Greece. We also show that the goodness-of-fit of the ICA-based model is better than other models used such as the Student's t copula model.     

New Directions in Risk Management

Following the 1991 recession, financial institutions investedheavily in risk management capabilities. These investments targetedfinancial (credit, interest rate, and market) risk management.I will show that these investments helped reduce earnings andloss volatility during the 2001 recession, particularly by reducingname and industry-level credit concentrations. I also suggestthat the industry now faces major risk challenges (better treatmentof operational, strategic, and reputational risks and betterintegration of risk in planning, human capital management, andexternal reporting) that are not addressed by recent investmentsand that will require development of significant new risk disciplines.     

The “forward premium puzzle” and the sovereign default risk

Carry-trade strategies which consist of buying forward high-yield currencies tend to yield positive excess returns when global financial markets are booming, whereas they generate losses during crises. Firstly, we show that the sovereign default risk, which is taken on by investing in high-yield currencies, may increase the magnitude of the gains during the boom periods and the losses during crises. We empirically test for this hypothesis on a sample of 18 emerging currencies over the period from June 2005 to September 2010, the default risk being proxied by the sovereign credit default swap spread. Relying on smooth transition regression (STR) models, we show that default risk contributes to the carry-trade gains during booms, and worsens the losses during busts. Secondly, we turn to the “Fama regression” linking the exchange-rate depreciation to the interest-rate differential. We propose a nonlinear estimation of this equation, explaining the puzzling evolution of its coefficient by the change in the market volatility along the financial cycle. Then, we introduce the default risk into this equation and show that the “forward bias”, usually evidenced by a coefficient smaller than unity in this regression, is somewhat alleviated, as the default risk is significant to explain the exchange-rate change.     

Volatility,the Macroeconomy,and Asset Prices

How important are volatility fluctuations for asset prices and the macroeconomy? We find that an increase in macroeconomic volatility is associated with an increase in discount rates and a decline in consumption. We develop a framework in which cash flow, discount rate, and volatility risks determine risk premia and show that volatility plays a significant role in explaining the joint dynamics of returns to human capital and equity. Volatility risk carries a sizable positive risk premium and helps account for the cross section of expected returns. Our evidence demonstrates that volatility is important for understanding expected returns and macroeconomic fluctuations.     

Information technology,contextual factors and the volatility of firm performance

This study uses previous theory developed in the IT implementation literature and the information processing view of the firm to empirically investigate the impact of IT investments and several contextual variables on the volatility of future earnings. We use InformationWeek 500 data on IT spending from 1992–1997 to find evidence that IT investments increase the volatility of future earnings but that this impact is highly contingent upon three firm level contextual factors — sales growth, unrelated diversification, and size. These factors can lead to conditions in which IT increases or reduces earnings volatility. Taken together, these results may help explain what has recently been termed the “new productivity paradox,” i.e., the apparent under-investment in information technology despite evidence of highly positive returns for doing so, and suggests settings where managers may be under- or over-discounting returns on IT investments.     

Extreme risk spillovers from commodity indexes to sovereign CDS spreads of commodity dependent countries: A VAR quantile analysis

Given the financialization of commodities and the increase in the CDS markets' size and structure, we examine the co-movement and dependence structure between four commodity indexes and sovereign credit risk via an extreme volatility risk spillover methodology. We use the daily change in sovereign CDS data between October 1, 2010 to March 31, 2020 for ten commodity-dependent countries and four commodity indexes (agricultural, precious and industrial metals, and energy). The results of White et al.'s (2015) VAR for Value at Risk (VaR) and the pseudo quantile impulse response function (QIRF) show that the volatility of the primary commodity export category (e.g., agriculture, mineral, and energy) substantially influences the volatility of sovereign spreads (except for two agriculture-dependent exporters). Still, it does not always have the strongest risk spillover effect when other commodity indixes are included in the analysis. When drilling down on the data and examining the single commodity index (i.e., gold, corn, etc.), our results indicate that the primary commodity exports significantly influence the volatility of its sovereign CDS spreads. Based on the results of the QIRF, most shocks are absorbed within 30 days. Most risk spillover from the volatility of sovereign CDS spreads to the volatility of commodity indexes is found to be insignificant.     

Evaluating the sovereign and household credit risk in Singapore: A contingent claims approach

This study evaluates the credit risk of the household and government (sovereign) sectors in Singapore using the contingent claims approach (CCA). The CCA model estimates the default probability of both sectors based on the market value of the assets and liabilities of the sectors. Compared to the traditional credit rating system, this model is able to provide numerical estimates of the exposures and default probabilities. We find that from the year 2000 to 2013, variations in the credit risk measures correspond to the economic growth of Singapore. In addition, we suggest that the main factor affecting the credit risks in the government and household sectors in Singapore is the volatility of the assets held by both sectors, given that the asset-to-distress barrier ratios are relatively stable over the past 14 years for both sectors.     

A Pyrrhic Victory? Bank Bailouts and Sovereign Credit Risk

We model a loop between sovereign and bank credit risk. A distressed financial sector induces government bailouts, whose cost increases sovereign credit risk. Increased sovereign credit risk in turn weakens the financial sector by eroding the value of its government guarantees and bond holdings. Using credit default swap (CDS) rates on European sovereigns and banks, we show that bailouts triggered the rise of sovereign credit risk in 2008. We document that post‐bailout changes in sovereign CDS explain changes in bank CDS even after controlling for aggregate and bank‐level determinants of credit spreads, confirming the sovereign‐bank loop.     

Pension plan accounting estimates and the freezing of defined benefit pension plans

This study provides evidence that, when “hard” freezing their defined benefit pension plans, employers select downward biased accounting assumptions to exaggerate the economic burden of their benefit plans. Downward biased expected rates of return and discount rates allow managers to increase reported pension expenses and, for discount rates, allow managers to increase reported pension liabilities. We find that prior to the Sarbanes-Oxley Act, both rates are downward biased when firms freeze their plans, whereas after SOX the bias is lower. This finding is consistent with managers opportunistically biasing pension estimates to obtain labor concessions during periods of reduced regulatory scrutiny.