Cost of Capital Emerging Markets

Instituto de Economia, Pontificia Universidad Catolica de Chile
COST OF CAPITAL IN EMERGING MARKETS:: BRIDGING GAPS BETWEEN THEORY AND

PRACTICE
Author(s): Eduardo Walker
Source: Latin American Journal of Economics , Vol. 53, No. 1 (DEC 2016), pp. 111-147
Published by: Instituto de Economia, Pontificia Universidad Catolica de Chile
Stable URL: https://www.jstor.org/stable/10.2307/90003535
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Vol. 53 No. 1 (DEC, 2016), 111–147
COST OF CAPITAL IN EMERGING

MARKETS: BRIDGING GAPS BETWEEN
THEORY AND PRACTICE*
Eduardo Walker**
An important parameter for asset and project valuation is the opportunity

cost of the capital invested, which depends on the systematic risks assumed.
Having many angles, the existing literature has not fully resolved the issue
for emerging markets. The evidence reviewed in this article suggests that
we should at least consider exposure to market risk and country credit
risk factors. After reviewing the theoretical and applied literature on
cost of capital determination and international asset pricing models, the
paper identifies and applies methodologies to determine discount rates
applicable to emerging markets for dif ferent countries and currencies and
develops methodologies for empirically measuring exposure to the country
credit risk factor.
JEL classifications: G31, G32, G12, G15, G24
Keywords: Cost of capital, emerging markets, market risk, credit risk,
currency risk
1. Introduction
This paper studies and develops a methodology consistent with the

academic literature and usual practice to estimate the cost of capital
for companies and industries based in emerging markets. This issue
has not been adequately addressed in literature. For example, there
are several international asset pricing models that calculate the returns
required for various asset classes (Bekaert et al., 2011), and academic
models do not account for the experience of practitioners (Abuaf, 2011).
Due to this gap, ad hoc models are frequently used to determine the
additional risk premium that an investor would require in order to
invest in emerging markets.
This paper begins by presenting a review of the literature on international
asset pricing models, of fering also a summary of specific “frequent”
* The author is grateful for the support of CONICYT through the Anillo SOC-04 project. He is especially
grateful for the help of Marcos Antonio Cruz Sanhueza on tax issues, the comments of Salvador Valdés,
and the comments of two anonymous referees. Any potential errors are purely the author’s responsibility.
** School of Management, Pontificia Universidad Católica de Chile, 4860 Vicuña Mackenna, Santiago,
Chile. Email: ewalker@uc.cl.
doi 10.7764/LAJE.53.1.111

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112 LATIN AMERICAN JOURNAL OF ECONOMICS | Vol. 53 No. 1 (Dec, 2016), 111–147
practices, then develops a method for estimating the exposure to

a second risk factor that relates to country risk, in addition to the
estimating exposure to the traditional market risk factor or Beta.
In some practical applications, sensitivity to a global risk factor is
“imported” from sensitivities to similar industries in developed countries.
We discuss the method to be used in such applications.
This paper also tackles several closely related issues, such as determining
the orders of magnitude of global risk premia, the relevance of using
geometric versus arithmetic means to estimate such premia from historical
data, the ef fect of taxation regimes in both emerging countries and the
investor’s own country on how to calculate the tax advantage of debt
(or equity in certain cases), and how to convert discount rates between
currencies. These issues are illustrated by applying our methodology
to several countries and currencies.
2. International asset pricing models:

theory and practice
Here we present a review of the financial literature, followed by a

discussion of the relevance of using conditional and unconditional
models, and then with a review of methods used by “practitioners.”
2.1 Academic literature review on international

asset pricing
The literature on international asset pricing is extensive, starting with

Sercu (1980) and Adler and Dumas (1983). This literature in general
extends the CAPM proposed by Sharpe (1964), Lintner (1965), and
Mossin (1966) by replacing the local market portfolio with a global
one. A partial review of this literature follows, with an emphasis on
emerging markets.1
The most appropriate pricing models will depend on the extent to
which international financial markets are integrated. This will depend,
in turn, on the openness of these markets, their transaction costs, and
their political stability. Integration implies using a single asset pricing
model to determine the cost of capital regardless of the country where
the capital asset is priced. We expect the relative importance of local
1. For example, Keck et al. (1998) have reviewed the previous literature.

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E. Walker | COST OF CAPITAL IN EMERGING MARKETS 113
risk factors to have decreased over time, since recent evidence reveals
that capital markets are becoming increasingly integrated (Carrieri
et al., 2007; Bekaert et al., 2011; Avramov et al., 2012).2
For example, Bekaert et al. (2011) measured integration as the average
difference between the local and global earnings-price ratio for each industry.
Using a sample of 20 developed and 49 emerging countries, they found
that segmentation declined over time. The local segmentation determinants
are capital flow restrictions, political risk, and the development of the
local stock market. The investment-grade corporate bond spreads in the
United States are a global segmentation determinant.3 Meanwhile, Hau
(2011) studied integration using a revision of the MSCI ACWI index
(in December 2000), as changing the reference index changed the Betas.
Assets whose Betas increase (fall) suffer price drops (increases) because
the required returns or discount rates change. This study provides direct
or causal evidence of integration, showing that it is important to use a
global equity portfolio return as the first risk factor.
Previous studies find local risk factors to be relatively more important.4
In any case, according to Bansal and Dahlquist (2002), these studies
would be subject to a “peso problem” bias, that could be caused by a
lack of credibility with regard to their commitment to keep markets
open (or to expropriation risk). After adjusting for this bias, the
systematic risk of the international CAPM model (with a single Beta)
would explain the dif ferences between countries’ expected returns.
Avramov et al. (2012) determined that, in addition to exposure to a
global market portfolio, exposure to a global credit risk factor (measured
as the dif ference between the equity returns for countries with low
and high risk ratings) is significant for explaining the dispersion of
2. Note that integration is not the same as correlation with a global market portfolio. Correlation
relates two variables and loses its meaning when there is more than one risk factor. See Pukthuanthong
and Roll (2009).
3. A segmentation ranking from highest to lowest for the period 2001–2005 found that Chile is at position
47, for example (from a total of 69, with the United States in the 69th place). Its earnings-price ratio
is 1.7 percentage points above that of the U.S., 0.4 percentage points above the average for developed
countries, and 1.9 percentage points below the average for emerging countries. Other countries are Argentina
(16), Brazil (15), Colombia (31), Ecuador (24), Korea (22), Mexico (45), Peru (30), and Venezuela (3).
4. Rowenhorst (1999) found that risk factors in emerging markets are qualitatively similar to those in
developed countries but with a bias toward local factors. Fama and French (1998) found that the return
on a global portfolio and a value premium would explain the international cross-section of returns, but
Grif fin (2001) argued that the explanatory power of the second factor is due to its local component.
Karolyi and Stulz (2003) found that using local or international models only implies significant dif ferences
for emerging economies. Erb et al. (1996) only used an aggregate country credit risk indicator to explain
the observed returns. Furthermore, the change in country risk premia would be partially predictable
using conditional models for the covariance with the global portfolio return (Ferson and Harvey, 1994;
Harvey, 1995).

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returns among countries, reducing the errors in international asset

pricing models, and underlining the importance of local factors.
Therefore, most of the studies reviewed have identified country credit
risk directly or indirectly as a second risk factor. Nevertheless, some
studies used exchange rate risk as a second factor.
Indeed, Hodrick and Zhang (2001) and Dahlquist and Sallstrom (2001)
found that exposure to exchange rate risks and the global portfolio
return explain the cross-section of returns. Zhang (2006) believed that
the exchange rate risk premia for developed countries are significant, that
there is evidence of integration and that the conditional international
CAPM augmented with exchange rate risk shows the best performance.
Antell and Vaihekoski (2007) studied Finland against the United States
for the period 1970–2004. They found that the global and local risk
premia vary over time, with the latter being relevant only for Finland,
and that there is a premium for exchange rate risk. Meanwhile, Chaieb
and Errunza (2007) found that the deviations with respect to purchasing
power parity (PPP) and segmentation are remunerated sources of risk.
In summary, given the evidence of increasing integration, it would be
appropriate to use international asset pricing models to determine
the cost of capital, with the first risk factor given by the exposure to
global equity risk. A second factor should be associated with exchange
rate risk or country credit risk.
2.2 Conditional vs. unconditional models
Conditional models allow the various parameters used to determine

discount rates to vary predictably over time, as do many of the papers
summarized above, whereas unconditional models involve relatively
constant parameters.
Conditional models have advantages: estimated Betas are not constant
and depend on the economic cycle (Zang, 2006); they better capture
structural changes in the risk premium (for example, Lettau et al.,
2008); the aggregate risk premium would be partially predictable (for
example, Lettau and Ludvigson, 2001; Cochrane, 2008; and Campbell
and Thompson, 2008), which can only be captured with conditional
models; reference interest (risk-free) rates clearly vary over time.
However, according to Simin (2008), there are two very dif ferent
questions in the literature: one is whether the average returns on

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the various assets conform to a risk-return model and another is

whether these models have out-of-sample predictive power. In order
to estimate discount rates, it seems reasonable to conclude that the
second question is more important.
Simin (2008) studied the out-of-sample performance of various models
using U.S. data, comparing them with simple prediction benchmarks.
Specific in-sample conditional models provide the best model fits. However,
out-of-sample predictions using these conditional models are weak. He
concluded that simple and “parsimonious” models would provide better
out-of-sample predictions. The best predictor over one- to five-year time
horizons for various portfolios and for all industries is the conditional
return of the market portfolio. The best predictor over periods longer
than five years is usually the historical simple average. Nevertheless,
predicting the risk premium remains a topic for discussion (for example,
see Campbell and Thomson, 2008 vs. Welch and Goyal, 2008).
2.3 Applied approaches
Damodaran
Damodaran (2003, 2012, 2015) is a standard reference for valuing

companies and projects. Therefore, his methods are explained in
some detail here.
He argued that if the marginal investor is global (local), the reference
portfolio should be global (local). Also, according to this author, the
Beta associated with a global portfolio (which is the only relevant risk
measure according to the Capital Asset Pricing Model, CAPM) would
not be a suf ficient parameter for determining asset or project risk in
the context of emerging markets. He argued that the total Equity Risk
Premium (ERP) for a country is the sum of the risk premium for a
Mature Market Risk Premium country (MMERP) plus an additional
risk Country Risk Premium (CRP). He recommended using the his
so-called “Implied Premium” for the MMERP, which is a conditional
estimate based on various ad hoc assumptions. The additional CRP
does not necessarily correspond to the spread of the corresponding
sovereign bonds. A dilemma is how to appropriately estimate the CRP
and the exposure of projects to this risk factor.
Damodaran (2015) argued that the CRP can be estimated from the
country’s Default Spread, from its corresponding Credit Default

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Swap (CDS),5 or from a “synthetic spread” for bonds with a risk

rating equal to that of the country where the project or company is
located. The CRP value can be obtained by multiplying the spread
by any of the following three “loadings”: (1) the relative volatility of
the country’s equity compared to the volatility of the S&P 500 Index;
(2) the relative volatility of local equity compared to the volatility
of local bonds; (3) the relative volatility of local equity compared to
the volatility of the CDS.
Therefore, based on this intuition, Damodaran (2003) proposed a
model using an ad hoc two factor model:
Required Return = Rf + β MMERP + λ CRP (1)
Here Rf is the long-term risk-free rate for a developed country, β is the

exposure to market risk,6 and λ is the company or sector’s exposure
to country risk.7 The author considered several possible measurements
of λ, recommending the relative volatility of the local stock market
compared to the volatility of local bonds. Therefore, he recommended
estimating the cost of equity capital using the following formula:
Required Return = Rf + β MMERP

(2)
+ λ(σEquity/σBonds) CDS
σEquity/σBonds is the relative volatility of a country’s equity returns

relative to its bond returns, and CDS is the Credit Default Swap for
that country.
Finally, a weighted average cost of capital (WACC) is used to calculate
the discount rate for future cash flows (Modigliani and Miller, 1958,
1963), which is the average of the cost of equity capital (obtained
from equation (2)) and the cost of debt.8 The cost of debt is taken
5. For example, towards the end of 2013 the ten-year CDS for Chile and Brazil were 100 and 230 basis
points, respectively (Bloomberg).
6. The covariance between the return of the industry or project and the market return, divided by the
variance of the market return.
7. The discount rate is expressed in the same currency as Rf.
8. For example, if the cost of equity capital is 8% and the cost of debt is 4%, and the company finances
its assets using 50% debt and 50% equity, the WACC is 6%.

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as the interest rate for issuers with a similar credit risk. The possible
tax advantages of using debt are discussed below, which reduce the
WACC, if they exist.
MacKinsey
Another important practical reference could be MacKinsey and

Company, as this is a global consultancy company with international
influence.9 Koller et al. (2010) presented their views and practices.
With a diversified global investor as a reference starting point, they
proposed using one of two alternative approaches: (1) modeling future
cash-flow scenarios, valuing each scenario, and then weighting them
according to the proabability assigned to each (in this case, they
argue that discount rates should not be adjusted for country risk
or exchange-rate risk); (2) the “business as usual” approach, with a
single sequence of expected cash flows. In this case, they would add
additional premia to the discount rate.
Koller et al. recommended using the CAPM model to calculate
the cost of equity capital in emerging markets (chapter 33). They
used the long-term United States bond yields as the risk-free rate,
adding projected inflation dif ferences (or dif ferences in interest rates
between currencies) to get the discount rate in local currency. They
estimated the Betas directly against a global index in U.S. dollars,
with five years of monthly data. They considered the risk premium
for a developed market and recommended taking the cost of debt in
local currency, adding the “systematic part of the credit spread,” which
relates to the credit risk of the issuer with respect to the risk-free rate
in U.S. dollars or euros. In the absence of local references, they used
an international credit spread with the same credit rating and then
added the inflation dif ferential. Finally, for the “business as usual”
approach, they recommended adding the country credit risk spread
to the weighted average cost of capital (WACC).
Abuaf (2011, 2015)
The final “applied” reference considered here is Abuaf (2011, 2015).

This author identified the “industry standard” as the CAPM, using the
9. http://www.mckinsey.com/.

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S&P 500 Index as a reference. The two risk factors used for emerging
markets are market and credit risk. He proposed adjusting for country
risk using the CDS, given the depth of that market (US$60 trillion).
The cost of equity capital must be estimated as in equation (1), using
the CDS as a second risk factor. Abuaf estimated the parameters
in a multiple return regression measured in U.S. dollars against the
return on the S&P 500 Index and the CDS rate (Abuaf, 2011). Later
he used changes in the CDS and not its level as a second explanatory
variable (Abuaf, 2015).
2.4 The asset pricing model proposed in this paper
Although there is no general consensus, for emerging markets most of

the literature reviewed identified the need not only for a global factor,
but for a second factor that reflects an additional source of risk. Karolyi
and Stulz (2003), Zhang (2006), Chaieb and Errunza (2007), and
Antel and Vaihekoski (2007) believed that the second factor is linked
to exchange rate risk, although Koller et al. (2010) argued that this is
not necessary, since it is already incorporated into the local currency-
denominated interest rate. Erb et al. (1996), Bansal and Dahlquist
(2002), Damodaran (2003), Abuaf (2011, 2015), and Avramov et al.
(2012) considered that the second risk factor is linked to the country
credit risk. Koller et al. (2010) proposed adding a country credit risk
spread to the WACC in the “business as usual” method.
Bekaert et al. (2011) found that during high credit risk periods in the
United States, there are greater differences in earnings-price ratios for
the same industries in different countries. They interpret this result as
segmentation. However, this may precisely reflect a second risk factor
that makes earnings-price ratios dif fer between countries due to a
second source of risk and not due to segmentation, since U.S. credit risk
spreads are highly correlated with credit default swap rates in emerging
countries, all of which are also highly correlated with each other.
The applied approaches studied do not explicitly consider exchange
risk as a second risk factor, using credit risk instead. It seems unlikely
that that those who don’t consider the exchange rate risk as the
second risk implicitly assume that this risk is diversifiable, given the
evidence analyzed above. It seems more likely that the reason for
not considering it is practical, since in principle it would be easier
to measure and verify the exposure to credit risk (through the CDS,
for example), than to measure the exposure to exchange rate risk.

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But this does not necessarily imply that they assume that there is no
exchange risk premium. It is tantamount to assuming that market and
credit risk span at least the same risk-return dimensions as market
and exchange rate risk. In fact, this paper presents estimates of the
possible magnitudes of the exchange rate risk premia for various
countries (Table 7).
Damodaran (2013, 2003) estimated the exposure to a second risk factor
using an ad hoc model. Avramov et al. (2012) provided a replicable
method, but their credit risk factor has not been updated and is
dif ficult to replicate. Therefore, it is useful and consistent with the
literature reviewed above to initially use each country’s credit risk
as a second factor. The equation for the cost of equity capital would
have the following form:
ke = Rf + βe MMERP + λeCDS (3)
Here ke is the cost of equity capital, Rf is the risk-free reference rate

in a developed country, MMERP is the mature market equity risk
premium, βe is the exposure to market risk, CDS is the country
credit default swap rate, and λe is the exposure to this risk factor.
Beyond dif ferences in leverage, it is reasonable to expect that βe and
λe depend on the industry to which the project or company belong.
As explained, Abuaf (2011) used the CDS level as a second risk factor
for estimating λe, but in order to adequately estimate the sensitivity
of returns to this risk factor, it is necessary to correlate it with some
multiple of the changes in the CDS spread and not with its level.10
This is partially corrected in Abuaf (2015), where he used the resulting
estimate for λe to categorize the industries into “low,” “medium,” and
“high” exposure to country risk, assigning values to λe of 0.35, 0.70,
and 1.0, respectively. These values do not have an explicit justification.
One contribution this paper makes is to propose a specific method for
estimating exposure to the second risk factor, λe.
When the regression (3) is estimated with changes in the CDS, it is
incorrect to interpret the second regression coef ficient as the multiple
10. For example, to empirically determine a bond duration, we should regress the proportional change
in the bond price against changes in its yield and not against the yield level.

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(λe) that should multiply the CDS spread or level. In fact, estimated in
this way the parameter should be negative, as an increase in country
risk would result in falling asset values. This point is explored below,
and we exploit the “replicating portfolio” concept in order to transform
in a consistent and useful way the sensitivity to changes in the CDS
spread into an additional risk premium.
3. The risk-free rate, the risk premia,

and the weighted average cost of capital
In this section, we discuss how to select the appropriate parameters

to estimate the cost of capital. First, we consider the risk-free rate.
Second, we discuss the market risk premium and the distinction
between arithmetic and geometric means. Third, we go on to measure
the credit risk premium. Fourth, we discuss the weighted average cost
of capital under dif ferent tax regimes.
Later, in section four, we study how to estimate the sensitivities to
these risk factors and also how to apply the proposed model.
3.1 The risk-free rate
The CAPM is a one-period model that does not address what the
relevant reference risk-free interest rate should be. Damodaran (2015)
recommended using a 20- or 30-year U.S. Treasury Bond’s nominal
interest rate (yield) in U.S. dollars. Koller et al. (2010) and Abuaf
(2011) proposed using a similar interest rate, but for a 10-year bond.
They justify using this rate as this bond is traded in significantly
more liquid markets than longer-term bonds. Curiously, Abuaf (2015)
changed his mind and proposed using a longer-term rate because it
would be “more realistic.”11
Conceptually, when we value a project or a company we should use the
spot interest rate and not an historical average, because the spot rate
reflects the opportunity cost for a risk-free project and incorporates
market expectations with regard to future interest rates. The Ef ficient
Market Hypothesis indicates that we should not expect a particular
11. “[The risk-free rate used is] … slightly higher than the current 30-Year Treasury bond, yet closer to
the long-term equilibrium rate that should theoretically approach growth rate of nominal GDP,” p. 76.

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analyst’s opinion to be systematically better than that of a deep

market, which incorporates the available information.
The specific maturity for the reference interest rate would be rather
arbitrary. Intuitively, it seems reasonable to consider a bond yield
whose maturity is consistent with the life of the asset being valued,
for example, equating durations. However, changing the reference
asset may also require an adjustment to the risk premium, since
risk premia already exist in the structure of interest rates.12 In any
case, this problem may be more closely associated with selecting the
appropriate pricing model, considering all the risk factors, rather
than the reference rate maturity. For example, it is possible that a
30-year bond is correctly priced using a three-factor model, including
the 10-year bond return (e.g. this instrument’s risk may be spanned
by the other risk factors).
The approaches discussed generally discount future cash flows projected
in nominal U.S. dollars. This is the most common practice. Another
possibility is to consider a real interest rate in U.S. dollars as a reference,
such as U.S. TIPs, if the expected cash flows to be discounted are
adjusted for inflation. This is not normal practice in developed markets.
A problem with this approach is that TIP interest rates incorporate
a significant illiquidity premium (Pflueger and Viceira, 2011), which
would result in inflation-adjusted discount rates being overestimated,
if no other adjustments were made.
We follow Koller et al. (2010) and Abuaf (2011) using a 10-year
nominal U.S. dollar (adjusted) yield as our reference risk-free rate for
convenience and comparability, although the use of interest rates of
bonds with dif ferent maturities would not cause any major practical
complications.
3.2 Global risk premia (MMERP)
A source traditionally used for the equity risk premium has been
the Ibbotson and Associates Yearbook, which for certain periods has
estimated this premium (historical, since 1926) for the United States
at more than 8 (6) percentage points with respect to short-term (long-
term) fixed income.
12. See Cochrane and Piazzesi (2005), Ludvigson (2009), and Dimson et al. (2015) for conditional and
long-term estimates, respectively.

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There is some consensus that the expected future value of the global
equity risk premium is overestimated, if we consider the past 50 years
or more to estimate it. Valuation multiples (such as price-earnings or
market-to-book ratios) have increased, and they cannot be assumed
to have a trend. Fama and French (2002) provided a milestone by
recognizing this, concluding that the expected risk premium is less
than half the historical average.
Koller et al. (2010) recommended using a premium with respect to long-
term bonds of between 4.5% and 5.5%. In their opinion, this parameter
is stable. To prove this, they transformed the median price-earnings
ratio of the firms within the S&P 500 Index into an expected return
by assuming a real long-term growth rate of 3.5% and a real return on
book equity of 13.5%, obtaining an inflation-adjusted average return
of 7%, which proves to be stable. This result obviously depends on
the assumptions for growth and the return on book equity.
Since 2001, there has been another important source of information
which is regularly updated. Dimson et al. (2015) incorporated 23
countries for the period 1900–2014 (115 years). They found a historical
geometric risk premium with respect to bills (bonds) for a global
portfolio of 4.3% (3.2%). The historical risk premium of long-term
bonds over short-term bonds is 0.9%. Dimson et al. (2013) arrived at
the premia presented in Table 1 after adjusting for expanding multiples
and other non-repeatable events.
Table 1. Risk premia
With respect to bills With respect to bonds
Geometric 3.0 to 3.5% 2.2 to 2.7%

Arithmetic 4.5 to 5.0% 3.7 to 4.2%
Source: Dimson et al. (2013).
A Chartered Financial Analysts (CFA) Institute publication (Hammond

et al., 2011) collected the estimates of 11 authors, academics, and
“practitioners.” The importance of this source is that it summarizes the
opinions of authors with a long history of publications on the subject.
They tend to agree that risk premia are lower than the historical
averages, but not in its absolute magnitude. Table 2 presents numerical
estimates from this publication.

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Table 2. Risk premia according to various authors
Premium with respect

Author Estimate Source explanation
to long-term bonds*
Total expected return

Asness 4% real 2 to 3%
on the S&P 500 Index
Geometric, over 10-year
Grinold et al. 3.6% 3.6%
Treasury bonds
Geometric, with respect
Arnott 2.5 to 3% 1.5 to 2%
to T-Bills
Geometric, with respect to
Ilmanen 3% T-Bills, assuming a 1% 2%
real return on T-Bills
Geometric, with respect
Chen 3.34% 3.34%
to long-term T-bonds
Siegel 5 to 6% Over 10-year Treasury bonds 5 to 6%
Source: Hammond et al. (2011).

*Implies a risk premium of long-term state bonds over short-term state bonds of 1%
A discussion about the use of conditional or unconditional models also

involves the risk premium, since it would be partially predictable based
on indicators such as the ratio of aggregate dividends to stock market
capitalization (Cochrane, 2008; Campbell and Thompson, 2008). However,
Welch and Goyal (2008) argued that this evidence is not conclusive.
Damodaran (2015) argued that there are several reasonable methods, but
that his implied equity premium (a conditional estimate whose foundation
is intuitive) would be preferable as it is “market neutral” (p. 105) and his
estimator is correlated with future returns,13 unlike Koller et al. (2010),
who recommended a constant premium of between 4.5% and 5.5%.
Simin (2008) found that the best predictor is the conditional market
return over terms of up to five years, and for longer terms, the best
predictor is constant. Therefore, the potential benefits of using
conditional predictions for the risk premium would be moderate, when
used for valuing assets with long-term cash flows.
3.3 Arithmetic vs. geometric averages

The relationship between arithmetic and geometric means is approximately
rArithmetic = rGeometric + 1/2 the return variance (4)
13. This correlation with future returns is probably based on overlapping returns and is biased upward.
See Ferson et al. (2003).

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For example, the standard deviation of the Dimson et al. (2013) global
equity portfolio return is 17.3%. This implies a dif ference between
arithmetic and geometric means of 1.5%.
Given the estimated risk premia found above (Tables 1 and 2), a
question is whether to use geometric or arithmetic means. This question
is technically complex. For example, Jacquier et al. (2003) proposed
using the following formula:
E(r) = rArithmetic(1-H/T) + rGeometric(H/T) (5)
Here E(r) is the expected return, H is the investment term, and T

the length of the sample used in the estimate. Koller et al. (2010)
used a similar method, based on Blume (1974). However, Jacquier
et al. recognized that this estimator is appropriate when estimating
an expected cumulative return, which is technically dif ferent from
identifying an unbiased estimator for the discount rate.14
Cooper (1996) found that even if returns are not independent over time
and including possible estimation errors, the arithmetic mean is still
the less biased estimator for the discount rate. Fama (1996) indicated
that if a project has constant expected flows, its value is obtained by
discounting the expected future cash flows with the arithmetic mean,
although this implies that the implicit probability distribution of
future cash flows will be increasingly biased to the right.
Therefore, there are no obviously better estimators for discount rates
than those based on arithmetic means. Damodaran (2015) justified
using geometric means, but the arguments of Cooper (1996) and Fama
(1996) do not appear to technically justify this practice. The same
objection applies to Koller et al. (2010).
If we use an equity premium with respect to long-term bonds, consistency
requires that the expected reference bond return for a given horizon
should be estimated using the bond yield and then adding one-half of
its return variance, in the same way as with equity returns.
14. In the first case, the potential estimation error is found in the numerator, and in the second case,
in the denominator.

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3.4 The second risk factor
The second risk factor is, in principle, each country’s credit risk. The credit
risk can be measured as the spread between the interest rate of a sovereign
bond in U.S. dollars (or Euros) and a reference interest rate for a low-risk
country, such as the United States or Germany. It can also be measured
using Credit Default Swaps (CDS). Both alternatives (sovereign spreads
and CDS) should give similar results due to arbitrage considerations, as
argued below. However, in practice these approaches can give different
results. The main reason is that the CDS market is significantly more liquid
than the sovereign bonds market. A second reason may be the absence of
sovereign bonds for the term sought, such as 10 years.
Given the greater liquidity and availability, we also measure the second
risk factor building upon the CDS of an individual country or upon
an average of several countries.
Figure 1 displays CDSs for various countries. It is the premium paid
by the purchaser of insurance that protects against an insolvency
event or issuer default. In the absence of transaction costs, selling
such insurance is equivalent to a long position in a risky bond financed
with a short position in a risk-free bond.
Figure 1. Credit default swaps (CDS)
10,000
1,000
Basis points
100
10
Norway
Sweden
Finland
Denmark
Germany
Austria
United Kingdom
Switzerland
Australia
New Zealand
Netherlands
Czech
Belgium
Japan
France
South Korea
Chile
Mexico
Pamama
Colombia
Peru
Brazil
Spain
Italy
Hungary
Portugal
Venezuela
Argentina
5-year CDS 10-year CDS
Source: Bloomberg, December 10, 2013.

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3.5 Weighted average cost of capital (WACC)
The weighted average cost of capital is obtained from the cost of

debt and the cost of equity for companies within a specific industry.
The objective is to obtain a discount rate for future expected asset
cash flows using the cost of debt and equity. Modigliani and Miller
(1958, 1963) showed that in the absence of taxes and transaction cost
the absence of arbitrage implies that the weighted average cost, of
capital should be independent of the financing structure (leverage)
of a company or project.
The WACC can be calculated by: (1) averaging previously estimated
discount rates for debt and equity; or (2) first estimating the asset
sensitivity to each risk factor, which is the weighted average of the
sensitivities for debt and equity, and then using the asset sensitivities
in the pricing model to obtain the cost of capital. Both alternatives
would give similar results if the same pricing model were valid for
pricing debt and equity. Which method to choose would thus only be
a matter of convenience. However, in principle the first alternative is
more eclectic, as it does not require that the same pricing model be
applicable to debt and equity. This is the approach taken by Damodaran
(2003) and Koller et al. (2010), for example.
The usual formula to estimate the weighted average cost of capital
based on Modigliani and Miller is the following:
D E
WACC = kd (1 − τC ) + ke (6)
D +E D +E
Where kd is the expected return on debt, ke the expected return on

equity, D/(D+E) is the relative importance of debt in the financing
structure at market prices, and τC is the corporate income tax rate. This
formula is frequently found in finance textbooks, but its dependence
on the tax regimes is often overlooked. Indeed, the formula not only
assumes that interest is deducted from taxable income, but also that
the company that uses more debt in its financing structure (ceteris
paribus) will increase the value of its assets. This is correct only under
the assumption of double taxation.
The assumption is wrong in various countries for dif ferent reasons.
For instance, corporate income tax in Chile is treated as a tax credit
paid on behalf of (downstream) companies or individuals who receive

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dividends (Hernandez and Walker, 1993, Table 2).15 Australia has

adopted a similar scheme to mitigate the tax incentives on debt
(Alexander et al., 2000). Corporate earnings are subject to corporate
income tax in Brazil, Colombia, and Peru, but dividends are not subject
to personal taxes.16 However, in all such cases, debt interest that has
not paid taxes upstream would be subject to personal marginal tax
rates on taxable income.17
A formula that includes the partial tax credit on dividends is as follows
(Alexander et al., 2000):
D E
WACC = kd (1 − τC (1 − γ)) + ke (7)
D +E D +E
Here, γ is the fraction of the marginal investors that have the right to a
tax credit. In Chile, these were all investors except pension funds, until
2013. In the other countries mentioned above, γ is close to 1, because
there are no new personal taxes (or downstream taxes) on income from
equity capital, whereas there are taxes on income from debt.
3.6 Bond yields vs. expected returns
One last point that deserves discussion in order to implement equation (7)
is the dif ference between the bond yield and its expected return. One
15. The Chilean tax reform introduced in 2014 means that this does not change when companies are
owned by other (investment) companies, but individual investors may only use 65% of the corresponding
corporate income tax as a credit for their personal taxes. (See note 17).
16. The tax codes for each country can be found here, www.sii.cl (Chile); www.afip.gov.ar (Argentina);
www.receita.fazenda.gov.br (Brazil); www.dian.gov.co (Colombia); www.sunat.gob.pe (Peru). I appreciate
the help of tax expert Marcos Antonio Cruz Sanhueza for this point.
17. When there are corporate taxes (τC) in addition to personal taxes (or downstream taxes) on capital
gains (τPS) and income from owning company debt (τPD), Miller (1977) shows that the value of a company
with debt is equal to the value of a company without debt, plus the tax advantages arising from the
debt as follows: GL = [1 − ((1 − τC)(1 − τPS)/(1 − τPD))]D. For example, if τPS = τPD we are back to
the original formula (6), which justifies the use of the formula even when there are personal taxes. But
if τC is a tax credit on behalf of τPS, as in Chile and Australia, then τC disappears from the formula. In
addition, if τPS = τPD, there is no tax advantage for using debt, and the asset’s discount rate should not
be reduced with leverage. If taxable income is subject to tax only once, as in Brazil, then τPS = 0. In
addition, if the marginal tax rate for companies and individuals is similar, once again using debt creates no
tax advantages. After the Chilean tax reform of 2014, there will be double taxation on 35% of corporate
taxable income, and as τPS = τPD, the expression for the tax advantage of using debt is GL = [0.35τC/
(1 − τPD)]D. As the maximum personal income tax rate will be 35% and the corporate income tax rate
27%, the tax advantage will be 14.54% of the amount of debt. But if net income is not distributed to
individuals but to investment companies, the tax advantage from using debt will continue to be nil.

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reason for such difference is the default probability. For example, taking
a Credit Default Swap of 200 basis points for an investment-grade
instrument (Baa) as a reference, using Moody’s (2008) non-payment
statistics, with a recovery rate of 37% over an investment term of five
years, the bond risk premium is 176 basis points, which is 24 basis
points less than the CDS. For example, if the WACC assumes 50%
debt, the dif ference between the bond yield and its expected return
on debt is only 12 basis points. So, for investment-grade debt, the
difference between the CDS and the risk premium may be unimportant.
However, these results may be very dif ferent for non-investment-grade
bonds. For example, Koller et al. (2010) reported that this adjustment
is only important for low-grade investment bonds.
4. Estimates and applications of the two risk-

factor model
The proposed method to estimate the coefficients β and λ for the risk
factors in equation (3) are as follows, along with applications for this model.
The returns on local asset classes are measured in U.S. dollars (USD),
from a global investor’s perspective. We use weekly data in order
to estimate the parameters based on a recent period with suf ficient
degrees of freedom. This is also consistent with industry practices
(Abuaf, 2011, 2015; Damodaran, 2003).18
4.1 First risk factor
The first risk factor is the weekly return on the S&P 500 Index in excess
of the return (Holding Period Return, HPR) of investing in 10-year
U.S. bonds. This factor is called market risk (MR). The correlation
between the S&P 500 Index and the MSCI All Country World Index
is typically greater than 0.95, with similar volatilities, so estimates
should be similar if we used the latter index as reference.
Measuring the excess returns over the HPR on 10-year bonds does
not generate significant dif ferences in the estimated Betas compared
with using total returns (and not excess returns) instead. However,
this is important for the interpretation presented below.
18. The professional computer terminal and services provided by Bloomberg by default use the same
settings.

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4.2 Second risk factor
The second risk factor is the credit risk factor (CRF). It is constructed
as follows.
In the absence of transaction costs, by arbitrage a CDS is equivalent
to a short position in a risk-free bond that finances a long position in
a risky bond (both in the same currency). Therefore, the reverse path
is followed: the yield of the 10-year U.S. Treasury bond (TB10Y) is
taken as a basis, plus the 10-year CDS for each country, resulting in
the yield for synthetic 10-year bond in U.S. dollars, with the same
credit risk as the country analyzed. As explained, this yield should be
similar to that of the corresponding sovereign bond in U.S. dollars, but
there may be dif ferences due to liquidity. The equivalent investment
strategy is to buy a 10-year Treasury bond and sell the country credit
risk insurance, receiving the spread in the absence of default.
Figure 2 shows the yields of our synthetic bonds for several countries
together with the yield for 10-year U.S. Treasury bonds.
Figure 2. Yields for synthetic bonds (SY) versus 10-year U.S.

Treasury bonds (TB10Y)
64
32
16
Yields (%)
1
J MM J S N J MM J S N J MM J S N J MM J S N J MM J S N J MM J S N
2008 2009 2010 2011 2012 2013
TB10Y CHL_SY PAN_SY
ARG_SY COL_SY PER_SY
BRL_SY MEX_SY VEN_SY
Source: Based on the author’s calculations with CDS and Treasury Yields from Bloomberg.
The synthetic yield in U.S. dollars is transformed into returns (Holding

Period Returns, HPR), assuming a strategy of buying and selling
the synthetic bond after a week. Then, we repurchase a newly issued

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synthetic bond and so on. This is very similar to estimating the return
as the change in the yield multiplied by the duration of the 10-year
bond. The weekly HPR of investing in 10-year U.S. Treasury bonds
is subtracted from that series of returns, resulting in a dif ference or
excess return. This excess return is the credit risk factor (CRFk) for
each country (k). Part A of Table 3 shows variances, co-variances,
and correlations between the estimated CRF for various countries.
These CRFs are highly correlated between countries, especially among
those with less risk. As presumed, the resulting CRF is almost identical
to minus the change in the CDS multiplied by a constant, which is
similar to the (Macaulay) duration of our synthetic bonds. Therefore,
if instead of using the country’s CRF as a second risk factor we use
the change in its CDS, the results will be qualitatively identical.
The estimated multiples are presented in Part B of Table 3. Table
3B shows the result of using the change in the average CDS of each
country in the sample, in addition to the average that excludes
Argentina and Venezuela. Using the latter measure gives virtually
the same results (in terms of correlation, not in the magnitude of
the coef ficients) compared to using the country’s own CDS, which
suggests the existence of a second risk factor that is common to all
countries in the sample.
Table 4 shows the sensitivity of each country’s CRF to the average
CRF for the countries included in the sample. We observe that the
constants are not significant and that the explanatory power of the
average CRF is significant in all cases, with lower explanatory power
for Argentina and Venezuela.
Results not shown indicate that each country’s CDS is very similar to
multiplying its sensitivity to changes in the average CRF (third row of
Table 4A) with the average CDS. The greatest dif ference occurs with
Argentina, which may reflect that the CDS is a poor risk premium
indicator for countries with high credit risk.

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Table 3A. CRF variances. co-variances. and correlations

between countries
MEX_FRC
ARG_FRC
VEN_FRC
PAN_FRC
CHL_FRC
PER_FRC
COL_FRC
BRL_FRC
ARG_FRC Cov 0.0060
Corr 1.00
BRL_FRC Cov 0.0006 0.0004
Corr 0.38 1.00
CHL_FRC Cov 0.0004 0.0002 0.0002
Corr 0.41 0.90 1.00
COL_FRC Cov 0.0006 0.0004 0.0002 0.0004
Corr 0.39 0.97 0.89 1.00
MEX_FRC Cov 0.0007 0.0004 0.0002 0.0004 0.0005
Corr 0.39 0.97 0.89 0.98 1.00
PAN_FRC Cov 0.0006 0.0004 0.0002 0.0004 0.0004 0.0004
Corr 0.39 0.97 0.89 0.98 0.98 1.00
PER_FRC Cov 0.0006 0.0004 0.0002 0.0004 0.0005 0.0004 0.0004
Corr 0.39 0.97 0.88 0.97 0.97 0.98 1.00
VEN_FRC Cov 0.0019 0.0005 0.0003 0.0005 0.0005 0.0005 0.0005 0.0019
Corr 0.56 0.55 0.63 0.56 0.54 0.54 0.55 1.00
Table 3B Sensitivity of each country’s CRF to changes

in its CDS
MEX_FRC
ARG_FRC
VEN_FRC
PAN_FRC
CHL_FRC
PER_FRC
COL_FRC
BRL_FRC
D(ARG_CDS) -3.5 -0.4 -0.2 -0.4 -0.4 -0.4 -0.4 -1.1

D(BRL_CDS) -9.9 -7.1 -3.9 -7.0 -7.4 -6.9 -7.1 -8.0
D(CHL_CDS) -18.8 -11.5 -7.7 -11.6 -12.2 -11.3 -11.6 -16.5
D(COL_CDS) -9.9 -6.8 -3.7 -7.0 -7.3 -6.7 -7.0 -8.0
D(MEX_CDS) -9.5 -6.4 -3.5 -6.5 -7.1 -6.4 -6.7 -7.3
D(PAN_CDS) -10.0 -6.9 -3.8 -7.1 -7.5 -7.0 -7.2 -7.8
D(PER_CDS) -9.6 -6.6 -3.6 -6.7 -7.2 -6.7 -7.0 -7.7
D(VEN_CDS) -4.4 -1.2 -0.8 -1.2 -1.2 -1.1 -1.2 -4.5
D(AVG_CDS) -13.5 -3.3 -2.0 -3.3 -3.5 -3.2 -3.4 -7.0
D(AV_IG_CDS) -11.0 -7.5 -4.2 -7.6 -8.1 -7.5 -7.7 -8.8
Source: Prepared by the author based on Bloomberg data. Sample: 2008 to 2013. 310 weekly observations.
Note: 100 CDS basis points are represented as 0.01 in the regression.

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Table 4. Sensitivity to the average CRF

HPRFRC,k − HPRTB10Y = φ0k + φ1k(HPREME − HPRTB10Y) + ek
A. Sample 2012-2013
ARG BLR CHL COL MEX PAN PER VEN
φ0k 0.00 -0.00 0.00 -0.00 0.00 0.00 0.00 -0.00

t-test 0.20 -1.58 1.45 -0.10 0.85 0.02 0.23 -0.18
φ1k 5.40 1.13 0.61 1.07 1.06 1.06 1.08 2.70
t-test 4.8 28.8 23.1 48.4 44.0 46.2 47.1 9.5
Adjusted R-squared 0.18 0.89 0.84 0.96 0.84 0.95 0.96 0.47
Durbin-Watson stat 1.82 1.51 1.51 2.28 2.52 2.44 2.19 1.94
B. Sample 2008-2013
ARG BLR CHL COL MEX PAN PER VEN

φ0k 0.00 -0.00 -0.00 0.00 -0.00 0.00 0.00 0.00
t-test 0.65 -0.65 -0.44 0.92 -0.27 0.66 0.16 0.44
φ1k 1.60 1.06 0.60 1.07 1.13 1.05 1.09 1.27
t-test 7.6 108.7 40.7 118.4 116.7 126.5 110.9 12.0
Adjusted R-squared 0.16 0.97 0.84 0.98 0.84 0.98 0.98 0.32
Durbin-Watson stat 1.87 2.11 2.11 2.35 2.36 2.16 2.41 1.61
Source: Author’s calculations based on Bloomberg data. Sample: 2008 to 2013, 310 weekly observations.
4.3 The two factors and the replicating portfolio
The estimated model for any asset class (j) based on an emerging
country is:
RjUSD − HPRTB10Y = αj + βj(RS&P500– HPRTB10Y)

(8)
+ λj(HPREME − HPRTB10Y) + ej
RjUSD − HPRTB10Y is the excess return in U.S. dollars of assets j over the
return on investing in 10-year U.S. Treasury bonds, RS&P500 − HPRTB10Y
is the excess return of these assets over the S&P 500 Index, and
HPREME − HPRTB10Y is the credit risk factor (CRF) for the excess
return on investing in a synthetic bond portfolio in emerging countries.
Note that if αj is not significantly dif ferent from zero, the equation
can be reordered, and taking the expected value, it becomes:

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E(RjUSD ) = (1 − βj − λj)E(HPRTB10Y) + βj E(RS&P500)

(9)
+ λj E(HPREME)
Equation (9) is interpreted as a “Replicating Portfolio.” In the absence

of arbitrage, the expected return on asset j must be equal to that of
its replicating portfolio, which invests 1 − βj − λj in Treasury bonds,
βj in the S&P 500 Index and λj in a synthetic bond portfolio with
a country risk equal to the average of the countries included in the
sample. This enables us to obtain a discount rate in U.S. dollars for
assets in emerging economies.
4.4 Estimated sensitivity to the risk factors (β and λ)
Table 5 presents estimates of risk parameters (β and λ) for stock indexes

in Latin American countries (equation (8)), with a single average risk
factor (Part A) and with the specific risk factor for each country (Part B).
In all specifications and samples, the parameters turn out to be very
significant. In addition, the constants are not significant, except for
Brazil and Chile in the most recent sample (2012 to 2013). This
validates in principle our interpretation that the coef ficients are the
weights of a replicating portfolio (equation (9)).
The Betas are relatively low, as this parameter’s value for the S&P
500 Index is 1, by definition. For example, for Chile, Colombia, and
Mexico the value is close to 0.5. This occurs because the credit and
market risk factors are significantly correlated. A simple regression
of the average CRF over the S&P 500 Index reveals a Beta (βCRF)
of 0.34 over the entire period and 0.16 for the 2012–2013 period.
This implies that if Betas are estimated using univariate regressions
with respect to the S&P 500 Index and then a second risk premium
associated with the country credit risk is added, part of the additional
premium would be included twice. This drawback has been ignored
by Damodaran (2003) and Koller et al. (2010).
Comparing the estimates with the average CRF and each country’s
CRF, the estimated Betas appear to be similar. The Lambdas change
as the reference risk factors also change, as is evident for Argentina.
Estimates for the cost of equity capital in U.S. dollars for each country’s
stock market are presented in the second half of Parts A and B of Table 5.

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134
Table 5. Estimated β and λ for aggregated stock markets and cost of equity capital
RjUSD – HPRTB10Y = aj + bj(RS&P500– HPRTB10Y) + lj(HPREME– HPRTB10Y) + ej
A) Average Credit Risk Factor
Sample 2012 to 2013 2008 to 2013
N. obs. 103 310
ARG BRL CHL COL MEX PER ARG BRL CHL COL MEX PER
Const. 0.02% -0.58% -0.36% -0.18% -0.40% -0.14% 0.08% -0.08% 0.03% 0.05% -0.06% 0.06%
t-test 0.05 -2.31 -2.22 -0.79 -1.36 -0.81 0.40 -0.43 0.20 0.33 -0.23 0.61
ER_SP500 (β) 1.05 0.93 0.54 0.52 0.49 0.83 0.82 0.99 0.62 0.60 0.60 0.85
t-test 7.94 10.17 8.31 5.23 3.86 11.02 11.79 13.68 10.82 10.77 6.81 18.85
AVG_FRC (λ) 0.65 1.33 1.29 1.01 0.84 1.30 0.74 1.10 0.60 0.62 1.00 1.16
t-test 1.67 5.85 7.80 4.04 0.34 5.23 5.68 6.73 4.15 4.46 7.05 11.94
R2 adjusted 0.31 0.56 0.60 0.42 0.22 0.63 0.59 0.74 0.61 0.58 0.49 0.86
DW 1.73 1.86 1.83 1.61 1.71 1.88 1.95 2.17 1.97 2.10 1.73 1.93

Estimated discount rate
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Risk free rate (1) 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9%

Risk free rate adj. to arithmetic (2) 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2%
Equity risk premium -- Arithmetic mean (3) 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%
Risk premium credit risk factor (4) 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6% 1.6%
Risk premium credit risk factor -- Arithmetic (5) 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5% 2.5%
Expected return in USD (6) 9.0% 10.2% 8.6% 7.8% 7.2% 9.8% 8.3% 9.9% 7.1% 7.1% 8.1% 9.5%
Recent sample minus total sample 0.7% 0.4% 1.5% 0.7% -0.8% 0.3% - - - - - -
LATIN AMERICAN JOURNAL OF ECONOMICS | Vol. 53 No. 1 (Dec, 2016), 111–147
Table 5. (continued)
B) Individual Credit Risk Factor
ARG BRL CHL COL MEX PER ARG BRL CHL COL MEX PER
Const. 0.00% -0.54% -0.40% -0.18% -0.41% -0.15% 0.06% -0.07% 0.05% 0.04% -0.05% 0.06%
t-test 0.01 -2.17 -2.56 -0.77 -1.36 -0.85 0.34 -0.37 0.29 0.26 -0.20 0.59
ER_SP500 (β) 1.09 0.96 0.51 0.52 0.48 0.85 0.96 0.99 0.62 0.59 0.62 0.87
t-test 9.46 11.38 6.79 5.28 3.62 11.90 13.58 14.12 11.36 10.71 7.16 19.44
AVG_FRC (λ) 0.07 1.25 2.01 0.92 0.74 1.13 0.13 1.05 0.93 0.60 0.81 1.02
t-test 2.74 6.01 8.61 3.77 2.18 5.28 3.81 6.81 5.72 4.40 6.22 11.23
R2 adjusted 0.34 0.59 0.60 0.42 0.22 0.62 0.58 0.74 0.62 0.59 0.49 0.86
DW 1.73 1.85 1.93 1.58 1.68 1.85 2.02 2.18 1.94 2.10 1.71 1.95
E. Walker | COST OF CAPITAL IN EMERGING MARKETS
Risk free rate (1) 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9%
Risk free rate adj. to arithmetic (2) 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2% 3.2%

Equity risk premium -- Arithmetic mean (3) 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%
Risk premium credit risk factor (7) 14.0% 2.3% 1.1% 1.6% 1.3% 1.5% 14.0% 2.3% 1.1% 1.6% 1.3% 1.5%
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Risk premium credit risk factor -- Arithmetic (8) 29.6% 3.4% 1.5% 2.7% 2.6% 2.6% 29.6% 3.4% 1.5% 2.7% 2.6% 2.6%
Expected return in USD (6) 9.7% 11.2% 8.1% 7.7% 7.0% 9.5% 10.9% 10.7% 7.0% 7.1% 7.7% 9.2%
Recent sample minus total sample -1.2% 0.6% 1.1% 0.6% -0.7% 0.2% - - - - - -
B)-A) (9) 0.7% 1.0% -0.5% -0.1% -0.2% -0.3% 2.6% 0.8% -0.1% 0.0% -0.3% -0.2%
Notes: (1) Yields on 10-year U.S. Treasury bonds, Dec. 13, 2013. Source: Bloomberg; (2) Adjusted by 1/2 of the annualized weekly HPR variance of the 10-year bond;
(3) Average of estimations by Dimson, Marsh & Staunton (2013), Table 1. Corresponds to arithmetic premia with respect to bonds; (7) Each country’s CDS as of Dec.
13, 2013. Source: Bloomberg; (8) Ajusted by 1/2 the annualized variance of each country’s FRC, period 2008−2013; (9) Difference between estimations with average
and individual credit risk factors. t-tests adjusted for autocorrelation an heteroskedasticity.
135
The results obtained from various samples and models are similar,
with proportionally small dif ferences. An exception may be the case
of Chile, where using the most recent sample results in a discount rate
1.4% greater than that obtained using the full sample. In addition,
apart from the relatively low discount rate for Argentina,19 the cost
of capital ranking among countries using the most recent sample is
perhaps puzzling. This may be due to the corporate leverage of firms
in each country’s stock market, as explained below.
4.5 Leveraged, un-leveraged, re-leveraged estimates

and WACC by country
Estimates of the parameters in Table 5 are af fected by industrial

composition and by corporate borrowing or leverage in each country.
The cost of equity capital is usually estimated (Damodaran, 2003;
Koller et al., 2010) by un-leveraging the risk factors (in this case β
and λ) then re-leveraging them while assuming a long-term leverage
level for the corresponding project or company.
Table 6 presents the aggregate leverage levels for public companies
in each country. Debt, net of cash balances, as a proportion of the
stock market capitalization is used as a leverage indicator. With these
numbers and certain additional assumptions, we obtain the parameters
for the average un-leveraged public company in each country.
It is usual to assume that the Beta for the debt is zero during this process
of un-leveraging and re-leveraging, but this is only an intermediate step.
Subsequently, the parameters are re-leveraged to obtain the cost of equity
capital. This assumption could be particularly inappropriate for below-
investment-grade companies or countries. Nevertheless, for the purposes
of the following calculations, we assume that the Beta for the debt is
zero. If d is the degree of leverage (D/E), the Beta for the assets (βU) is:20
βU = βL/(1 + d) (10)
19. When the country credit risk is high, such as for Argentina, there is segmentation; see Bansal and
Dahlquist (2002).
20. In fact, the result of equation (10) should be βU = βL/(1 + d) + βD(d)/(1 + d), where βD is the
Beta for the debt. Re-leveraging equation (10) with a debt-equity ratio objective of d * results in
βL* = βL(1 + d *)/(1 + d). Re-leveraging the result without the approximation of assuming that βD = 0
results in βL** = βL(1+d *)/(1+d ) + βD(d )(1 + d *)/( 1 + d ). Thus, the error for assuming that the Beta
for the debt is zero is approximately βD(d * − d )d, which presumably will be small.

192.188.53.214 on Wed, 17 Apr 2024 22:51:41 +00:00
We must also obtain λU, which is sensitive to the credit risk factor of
the un-leveraged company. λU is the weighted average of the sensitivities
of debt (λD ) and equity (λL ). In this case, it is inappropriate to
assume that λD = 0, because we consider assets or companies that have
inherited their own country’s risk. For the purpose of un-leveraging
these parameters, we assume that λD is equal to the sensitivity of the
country’s credit risk factor to the average credit risk. This parameter
was estimated and presented in Table 4. For example, this sensitivity
is 1.13 for Brazil and 0.61 for Chile. Thus,
λU = λD d/(1 + d) + λL/(1 + d) (11)
The weighted average cost of capital (WACC) in each case can be

obtained using the parameters βU and λU. This is presented in the
sixth column of part B of Table 6. The discussion presented earlier
supports the assumption that there are no tax advantages to using
debt for the countries in the sample.
Finally, to illustrate common practice, the results are re-leveraged in order
to determine the cost of equity capital, assuming a leverage level equal to
the weighted average of the sample (d) of 0.44. The sensitivities can be
estimated by clearing βL and λL from equations (10) and (11), respectively.21
4.6 “Imported” Betas and the incremental credit risk

premium
Due to information availability, often industry Betas are “imported” from

companies based in developed countries, which are then adjusted in order
to evaluate an asset or project in an emerging country. The un-leveraging
and re-leveraging process can be performed with imported Betas.
As explained, estimating Betas with univariate regressions with respect
to indices of developed countries and then separately adding a country
risk premium may result in the same risk factor being included twice.
21. The resulting cost of capital for Argentina proves to be abnormally below the average of other
countries, which is surprising given its risk rating. This result is due to the local stock market having
a low estimated sensitivity to the average credit risk of Latin American countries. This may reflect
segmentation in this market. Pricing models that assume integration understate the cost of capital in
segmented markets. See Bansal and Dahlquist (2002).

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It can be shown that estimating Betas with univariate regressions (for

example, with respect to the S&P 500 Index) for country or industry
k, leads to the following result:
βkTOT = βk + βCRFλk (12)
Where βkTOT is the Beta of a univariate regression, βk is the regression

coef ficient with two risk factors, βCRF is the sensitivity of the credit
risk factor to the S&P 500 Index, and λk is the sensitivity of the local
stock market (or industry or local company) to the credit risk factor.
Therefore, if we use an imported univariate Beta to calculate the cost
of capital, the incremental risk premium associated with the second
must be estimated as:
CDS − βCRFMMERP (13)
This premium is clearly less than the average CDS, given that βCRF is
positive. We would need to subtract between 80 and 160 basis points
from the CDS levels (adjusted by convexity), depending on the sample
period considered, which results in an incremental risk premium of
between 180 and 90 basis points, respectively.22 Only this incremental
premium (and not the total CDS spread) must be multiplied by the
exposure to the second risk factor λk and added to the cost of capital
for an equivalent company or project in a developed country.
If an estimate of λk for the specific industry is not available, the
average exposure for the country can be used as an approximation,
whose levered and un-levered estimates are presented in Table 6.
4.7 Converting discount rates into other currencies
Finally, we may need to convert discount rates from one currency to

another.
Koller et al. (2010) argue that adjusting for dif ferences in expected
inflation between currencies is suf ficient. For example, if the estimated
discount rate in local currency is an inflation-adjusted rate (to discount
22. See the notes to Table 5.

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Table 6. Leveraged, un-leveraged, and re-leveraged estimates, and WACC by country
Agg Mkt Cash/ Net Agg Debt/ Median Net

N° Firms Agg Debt Agg Cash Assets
Cap Assts Equity Debt/Equity
Argentina 62 $19,534 $6,272 $51,739 $71,273 0.09 0.26 0.26

Brazil 175 $404,263 $62,441 $491,847 $896,110 0.07 0.69 0.41
Chile 128 $176,318 $31,226 $232,647 $408,965 0.08 0.62 0.42
Colombia 41 $74,215 $28,313 $189,704 $263,919 0.11 0.24 0.18
Mexico 100 $188,498 $51,082 $516,406 $704,904 0.07 0.27 0.19
Peru 62 $40,759 $30,934 $82,877 $123,637 0.25 0.12 0.18
Total 568 $903,588 $210,267 $1,565,219 $2,468,807 0.09 0.44 0.27
Equity Cost
Country Debt Leveraged Leveraged Un-leveraged Un-leveraged Cap. Cost Re-leveraged Re-leveraged
of Capital
Lambda Beta Lambda Beta Lambda Asset Beta Lambda
Re-leveraged
Argentina 5.40 1.05 0.65 0.84 1.62 10.6% 1.21 -0.06 7.8%
Brazil 1.13 0.93 1.33 0.55 1.25 8.5% 0.79 1.30 9.6%

Chile 0.61 0.54 1.29 0.33 1.03 7.1% 0.48 1.22 8.2%
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Colombia 1.07 0.52 1.01 0.42 1.02 7.4% 0.61 1.00 8.1%

Mexico 1.06 0.49 0.84 0.38 0.88 6.9% 0.55 0.81 7.4%
Peru 1.08 0.83 1.30 0.74 1.27 9.4% 1.07 1.36 10.9%
Total 1.10 0.68 1.10 0.47 1.10 7.8% 0.68 1.10 8.6%
Source: The original data for aggregate debt (Agg Debt), aggregate cash (Agg Cash), market capitalization (Agg Mkt Cap), and Assets. Data Page of Aswath Damodaran
(http://pages.stern.nyu.edu/~adamodar/), corresponding to data updated to December. 2013. Numbers in millions of USD. (1) Debt minus cash over market cap; (2)
Obtained as the slope coef ficient of regressing each country’s credit risk factor against the average risk factor (see Table 4, sample 2012-2013); (3) See Table 5, sample
2012-2013; (4) Assumes Beta of Debt equal to zero and is obtained as (Leveraged Beta)/(1+D/E), where D/E net debt to equity; (5) Obtained as: (Country Debt
Lambda)*(D/E)/(1+D/E) + (Leveraged Lambda)*(1/(1+(D/E)); (6) Uses the premia from Table 5; (7) Beta and Lambda are re-leveraged assuming an average D/E
equal to 0.44; (8) Calculated with re-leveraged parameters and uses premia from Table 5.
139
inflation-adjusted cash flows) with an expected U.S. inflation of 2%,

we simply subtract 2% from the cost of capital in U.S. dollars.
Alternatively, we can take as a reference the long rate in local currency
and the equivalent rate in U.S. dollars with the same country risk. For
example, we can start with the interest rate on the “synthetic” bonds,
as described above, then add the dif ference between the rate in local
currency and the synthetic rate in U.S. dollars to the cost of capital
in U.S. dollars. The dif ferences in expected inflation and exchange
rate risk premia will be reflected in the dif ferences between interest
rates, but in this case are market-determined.
These calculations are presented in Table 7. The third column shows
the dif ferences between nominal interest rates in local currency and
the corresponding synthetic rate in U.S. dollars. These dif ferences are
added to the discount rate in U.S. dollars to obtain the corresponding
rate in local currency (the nominal rate in this case).
Finally, we need to consider that the interest rate differential in various
currencies relating to the same issuer (e.g., a country) may not only
reflect devaluation expectations, but also a currency risk premium. This
means that the rate in local currency will be “too high” with respect
to a risk-neutral case. Thus, the additional currency risk premium
should be subtracted from the dif ferential between rates. This point
is not fully explained here. We merely suggest a method to take into
account this possibility.
This can be seen in Table 7. We assume that each country’s currency
(in reality, the short-term bonds in each country’s currency) are also
part of integrated markets that are valued according to the two-risk-
factor model used in this paper. As shown in columns 4 and 6 of
this table, some currency Betas and all their Lambdas are significant
(with the exception of Argentina, whose currency does not float).
This corroborates the conjecture that a relationship exists between
exchange rate and credit risks. Column 7 shows an estimate of the
exchange risk premia implicit in local interest rates. The last column
shows the dif ferential between rates adjusted for the implicit risk
premium, which is subtracted. The results are mixed. For Brazil, the
rate in BRL should be 5.3% higher than the corresponding rate in
USD. For Chile and Mexico, the rate should be lower by slightly more
than 1%. For Colombia and Peru, the dif ferences are close to zero.

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Table 7. Adjustments to discount rates in USD
Synthetic Yield 10-year local Yield Diferential

10-year bonds currency bond
Yield β t-test λ t-test
Currency risk
minus currency
Differential currency(3) currency(3) premium (%)(4)
USD (%)(1) yields (%)(2) risk premium
Argentina 16.9 24.9 8.0 -0.00 -0.05 -0.01 -0.10 -0.0 8.0
Brazil 5.2 12.8 7.6 0.11 2.27 0.75 6.15 2.3 5.3
Chile 3.9 5.2 1.3 0.03 0.70 0.97 7.99 2.6 -1.3
Colombia 4.5 6.8 2.3 0.00 0.08 0.65 5.33 1.7 0.6
Mexico 4.2 6.4 2.2 0.13 2.75 1.14 9.38 3.4 -1.2
Peru 4.6 5.7 1.0 -0.04 -0.96 0.41 3.38 0.9 0.2

Dates around Dec. 13, 2013. (1) Source: Bloomberg, al 13-dic-2013; (2) ARG: Bocon 2022 (Source: www.puentenet.com); BRL Source: Global Financial Database
192.188.53.214 on Wed, 17 Apr 2024 22:51:41 +00:00

(GFD); CHL BTP a 10 años. Source: LVA Índices; COL. Source:GFD; MEX: GFD; PER: investing.com; (3) Estimated simultaneously against the two risk factors,

sample 2012-2013; (4) Corresponds to
141
5. Summary and conclusions
This paper develops a methodology consistent with the academic

literature and financial industry practice to estimate the cost of capital
in emerging markets. Our research shows that in many aspects, this
is an open issue.
The literature review concludes that there is no consensus regarding
the most suitable international asset pricing model for calculating
discount rates for emerging countries. In addition, the criteria used
by dif ferent practitioners are not fully aligned, nor are they consistent
with the academic literature. Ad hoc models are frequently used.
As others, we adopt the perspective of a global investor, taking the
U.S. dollar as the reference currency. We estimate a two-factor model
for fixed income, currencies, and equity in emerging countries. The
factors are the market risk, measured as the S&P 500’s returns in
excess of a risk free rate, and credit risk, measured as the excess return
of a synthetic bond portfolio with average Latin American country
risk. A contribution of this paper is a methodology to determine the
second risk factor and the exposure to it. These two risk factors also
have a significant explanatory power regarding stock market returns
and currency returns for each country in the sample, suggesting an
appropriate implicit consideration of exchange rate risk.
The paper also discusses several applied issues, which are important
when calculating discount rates in general:
■■ The global risk premium is about 4% with respect to long-term
bonds.
■■ According to the literature review, the appropriate estimate
of the market risk premium is the forecasted arithmetic mean,
both for fixed income and for equity investments.
■■ Using the average CDS as the second risk factor, the average
credit risk premium (adjusted to its arithmetic mean) is 2.5%
for the countries in the sample.
■■ The sensitivity of each country’s sovereign risk to the average
credit risk factor is ranked as follows, from smallest to largest:
Chile (0.6); Mexico, Panama, Colombia, and Peru (around 1);
Venezuela (2.7); and Argentina (5.4).

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■■ There are dif ferences between debt yields and their expected
returns. The latter, and not the yields, should be used to estimate
the cost of capital, but the adjustment is important only for
non-investment-grade companies or countries.
■■ Assuming tax advantages of using debt when estimating the
weighted average cost of capital is inappropriate in several
emerging countries.
■■ We explain how risk factors should be “un-leveraged” and then
“re-leveraged” in the context of the proposed multifactor model.
■■ Sensitivity to the global risk factor (or Beta) for some applications
is derived from similar industries in developed countries. We
discuss the relevant issues for this case, which essentially comes
down to avoiding a double counting of the same risk source.
■■ Finally, we explain how to convert discount rates to local currency.
The following results are of interest.
First, applying the two-risk-factor model to Latin American stock indices
to obtain the discount rates gives similar results across various samples
and specifications. For example, there are no significant dif ferences
when we use the specific country credit risk or the average credit risk
of investment grade countries as the second risk factor.
Second, the cost of capital tends to align itself with the country risk
measured by the CDS when the effect of aggregate leverage for the listed
companies included in the indices for each country is considered. The
markets with greater sensitivity to market risk (β) also tend to have
greater sensitivity to credit risk (λ), based on un-leveraged estimates.
Finally, market and credit risk factors are positively correlated. Therefore,
when estimating market β’s in a univariate regression, that parameter
will be overestimated with respect to the simultaneous estimation
of two risk factors. In this case, the additional credit risk premium
should be adjusted downwards by between 80 and 160 basis points.
In summary, this paper presents a methodology that suggests a step-
by-step process to estimate the cost of capital for emerging countries,
in a manner consistent with theory and practice.

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Instituto de Economia, Pontificia Universidad Catolica de Chile

COST OF CAPITAL IN EMERGING MARKETS:: BRIDGING GAPS BETWEEN THEORY AND

Instituto de Economia, Pontificia Universidad Catolica de Chile is collaborating with JSTOR to

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COST OF CAPITAL IN EMERGING

An important parameter for asset and project valuation is the opportunity

This paper studies and develops a methodology consistent with the

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practices, then develops a method for estimating the exposure to

2. International asset pricing models:

Here we present a review of the financial literature, followed by a

2.1 Academic literature review on international

The literature on international asset pricing is extensive, starting with

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returns among countries, reducing the errors in international asset

2.2 Conditional vs. unconditional models

Conditional models allow the various parameters used to determine

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the various assets conform to a risk-return model and another is

2.3 Applied approaches

Damodaran (2003, 2012, 2015) is a standard reference for valuing

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Swap (CDS),5 or from a “synthetic spread” for bonds with a risk

Required Return = Rf + β MMERP + λ CRP (1)

Here Rf is the long-term risk-free rate for a developed country, β is the

Required Return = Rf + β MMERP

σEquity/σBonds is the relative volatility of a country’s equity returns

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Another important practical reference could be MacKinsey and

Abuaf (2011, 2015)

The final “applied” reference considered here is Abuaf (2011, 2015).

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2.4 The asset pricing model proposed in this paper

Although there is no general consensus, for emerging markets most of

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ke = Rf + βe MMERP + λeCDS (3)

Here ke is the cost of equity capital, Rf is the risk-free reference rate

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3. The risk-free rate, the risk premia,

In this section, we discuss how to select the appropriate parameters

3.1 The risk-free rate

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analyst’s opinion to be systematically better than that of a deep

3.2 Global risk premia (MMERP)

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Table 1. Risk premia

With respect to bills With respect to bonds

Geometric 3.0 to 3.5% 2.2 to 2.7%

Source: Dimson et al. (2013).

A Chartered Financial Analysts (CFA) Institute publication (Hammond

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Table 2. Risk premia according to various authors

Premium with respect

Total expected return

Source: Hammond et al. (2011).

A discussion about the use of conditional or unconditional models also

3.3 Arithmetic vs. geometric averages

rArithmetic = rGeometric + 1/2 the return variance (4)