Are country and size risks priced in the Brazilian stock market?
| Autor | Sanvicente, Antonio Zoratto |
| Cargo | Report |
Abstract
When estimating a firm's cost of equity for valuation and other purposes in emerging markets without (or with only partial) capital market integration, many practitioners include a premium for country risk. In principle, the inclusion of such a risk factor would be justified if the particular country of interest was not sufficiently integrated into the global capital market. Initially, the paper measures and tests the degree of integration for the Brazilian market and does not reject the hypothesis of integration. The paper then tests directly the relevance of country risk premium in individual stocks' expected returns in the Brazilian market. Monthly data for the stocks of 57 of the most actively traded, non-financial firms, over the 2004 to 2014 period are used, using EMBI (Emerging Markets Bond Index) as a proxy for country risk, and this is found not to be significant. Finally, a premium for the size factor, also commonly used by practitioners, is also tested. Although it is found to be significant, the premium is negative, in contrast with current practice, which entails the addition of a positive premium to the required returns on small stocks. The inclusion of both a country risk and a size premium, in addition to the market portfolio risk premium, corresponds to the use of the Goldman Sachs model, as proposed by Mariscal and Lee (1993).
Key words: capital market integration; country risk; size risk; systematic risk.
Introduction
It certainly goes without saying how crucial the estimation of a firm's cost of equity is, especially for practical purposes--for equity and firm valuation in mergers and acquisitions, security analysis for investment recommendation purposes, for the determination of value creation by managers, and various other essential corporate finance decisions.
The starting point in most of the current practice is to begin with the Sharpe-Lintner-Mossin (SLM) version of the capital asset pricing model (CAPM), in which values for the rate of return on a proxy for the risk-free asset and a premium for exposure to market portfolio risk would be sufficient, including an estimate for the asset's degree of exposure (beta).
However, in many cases practitioners add premiums for other risk factors, for at least two reasons: (a) they do not believe the SLM version of the CAPM is valid, as indicated by the Fama and French (1992) results, or (b) they feel the need to adjust the SLM version of the CAPM for conditions in the specific market in which an investment is to be evaluated. For the first reason, a premium for the companies' size is frequently added (following the conclusions of Fama & French, 1992). An example of the second reason is the addition of a premium for country risk, in the belief that the country's market is not sufficiently integrated into the world market, so that this country risk would not be diversifiable, from the perspective of an international investor. This procedure is reported through a survey by Keck, Levengood and Longfield (1998).
The so-called Goldman Sachs model, attributed to Mariscal and Lee (1993), consists in the use of proxies from a developed, integrated market, such as that of the United States, for both the risk-free asset (e.g., US Treasury bonds) and the market portfolio (e.g., the S&P500 index). With such data, a U.S. investor would evaluate investments in her domestic market. However, if the investor was evaluating an investment opportunity, say, in Brazil, the Goldman Sachs model would recommend the addition of a premium for Brazil risk (e.g., the EMBI+ Brazil index), measuring the spread between the yields on Brazilian sovereign bonds and US Treasury bonds.
Even though it is not clear that the evaluation is being performed for the benefit of an international investor, local market evaluations make frequent use of the Goldman Sachs model. In a survey of 52 valuation reports for going-private purchase offers, as required by the corresponding Brazilian regulation, covering the 2008-2013 period, Sanvicente (2015) finds that in all reports an adjustment is made for country risk, using, in over 50% of the cases, the EMBI+ published by JP Morgan. In turn, the risk-free asset is proxied by 10- or 30-year US Treasury bonds, and the market portfolio is represented by the S&P500 index, the market risk premium being measured with average historical returns. Hence, it can be claimed that at least 50% of these particular applications of cost of equity estimation methods make explicit use of the Goldman Sachs model. An also frequent procedure is to add a positive premium for a size factor, particularly when the firm being evaluated is classified, somewhat arbitrarily, as a small firms.
The objective of the present paper is, therefore, to determine the empirical relevance of the Goldman Sachs model to the estimation of the cost of equity for the Brazilian market. This is accomplished both directly, through a test of the significance of a country risk premium for equity expected returns in a factor model, and indirectly, by testing whether the Brazilian market is partially or fully integrated into the world market, using the incremental risk measure proposed by Keck et al. (1998). The paper also tests the significance of the size premium in a multifactor model, as in Fama and French (1992) for the equities' expected returns. Other risk factors considered in the Fama and French (1992) 3-factor model (the value-growth factor) or in the Fama and French (2015) 5-factor model (value-growth, investment, and profitability) are not tested in the present paper, since our direct goal is to test the Goldman Sachs model as currently used in Brazil, that does not include the Fama-French factors identified within the parentheses.
The paper is structured in this manner: following this Introduction, a discussion of the relevant literature is presented, the methodology used for both tests is explained, data definitions and sources are provided, results are displayed, and the paper then is concluded.
Review of Literature
Country risk and market integration
Country risk is an important factor in a cross-border investment, especially in a not fully integrated market. One of the basic issues in the choice of a model as a basis for the estimation of cost of equity and discount rates in general, when dealing with investments outside the domestic economy, is the perception of how integrated the particular overseas market is, and whether one should adjust a basic model for non-diversifiable risks, such as country risk, or similar manifestations of emerging market risks, such as political or currency risk.
It is reported in the literature that investors tend to adjust their valuation methodology as a function of their perception of how much the particular market is integrated into the world market (Keck, Levengood, & Longfield, 1998). It is also emphasized that it is possible to construct a parallel between cost of equity computation methods and a market's degree of integration (Fuenzalida & Mongrut, 2010; Harvey, 2005; Stulz, 1999).
For fully integrated markets, Stulz (1999) argues that firms should adopt a discount rate treating them as part of the world stock portfolio. Global portfolio diversification would then lead to risk reduction and hence to the lowering of required returns. In this case, home investors can freely invest in foreign assets, and international investors can invest in domestic assets (Bekaert, Harvey, & Lundblad, 2003). As a consequence, if markets were fully integrated, country risk would be irrelevant in the estimation of the cost of equity, since it could be eliminated via diversification (Harvey, 2005).
It may also be observed that the covariance of returns with a global factor may have low explanatory power for expected returns in a segmented market. This dynamic will change when an economy moves from segmented to integrated. Expected returns, return volatilities and correlations with major global market indices would be affected in that process (Bekaert & Harvey, 1995; Bekaert, Harvey, & Lumsdaine, 2002; Errunza & Miller, 2000; Henry, 2000).
Country risk and global diversification
Global diversification can lower the cost of equity. Henry (2000) observes that a country's market index, when the economy is in a process of liberalization, achieves abnormal returns of approximately 3.3% on a monthly basis (in real US dollar terms) for eight months since the inception of liberalization policies. This result is consistent with the contention that liberalization policies help to lower the cost of equity level in a given country, since international risk diversification now becomes possible (Bekaert et al., 2002; Errunza & Miller, 2000; Henry, 2000; Stulz, 1999).
Despite such benefits from international portfolio diversification, in practice investors have preferences for domestic assets. This is the so-called home bias, leading agents to invest in the assets that are more familiar to them, ignoring the principles of portfolio theory, even if markets were fully integrated (Huberman, 2001). In other words, people invest disproportionately more in domestic assets than in foreign assets (Sercu & Vanpee, 2007). For example, many emerging-market investors are barred from investing in foreign company shares, due to government regulation and/or constraints imposed by their investing partners. Therefore, even when there is market integration, insufficiently diversified portfolios may result from purposeful actions, making country risk relevant.
Country risk and cost of equity models
There are different equity pricing models. They may be classified into three main segmentation/integration categories: segmented, fully integrated, and partially integrated markets (Bekaert & Harvey, 1995). It is possible to associate cost of equity estimation methods with a market's degree of integration (Fuenzalida & Mongrut, 2010; Pereiro, 2001; Stulz, 1999), as is...
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