The Term Structure of Country Risk and Valuation in Emerging Markets

Abstract

Most practitioners add the country risk to the discount rate when valuing projects in Emerging Markets. This practice does not account for the fact that the default risk term structure can be nonflat. The mismatch between the duration of the project under valuation and the duration of the most widely used measure of country risk, J.P. Morgan's EMBI, leads to an overvaluation (undervaluation) of long-term projects when the term structure of default risk is upward (downward) sloping. Using sovereign bond data from five Emerging Markets, we estimate a simple model that captures most of the variation of conditional default probabilities at different horizons for a given country at one point in time. This model can be used to solve the misestimation problem. JEL classification codes: G15, G31 CS is the credit spread between the yield of a U.S. dollar-denominated EM sovereign bond and the yield of a comparable U.S. bond, and the term preceding the last parenthesis is an "adjusted beta", that is equivalent to 60% of the ratio of the volatility of the domestic market to that of the U.S. market. 2 1 Neumeyer and Perri (2001) find that output in Argentina, Brazil, Korea, Mexico and Philippines is at least twice as volatile as it is in Canada.2 The 60% adjustment is due to the finding that 40% of the volatilities of domestic markets are explained by variations in credit quality --see Godfrey and Espinosa (1996) for details.

Long-duration bonds and sovereign defaults

“…We solve the model assuming that the government issues bonds that have a duration of four years-similar to the average duration in emerging economies, as documented by Cruces et al (2002) and Cunningham et al (2001)-and show that the predictions of the model change compared to the predictions obtained with one-quarter bonds: The mean and the standard deviation of the interest rate in simulations of the model increase significantly when we increase the bond duration. This narrows the gap between the predictions of the model and the data.…”

“…Note also that the one-period-bond model is a particular case of our framework: It corresponds to δ = 1, 4 Empirical studies and credit rating agencies use measures of duration of sovereign bonds based on this definition. See, for example, Cruces et al (2002) and Cunningham et al (2001). Copeland and Weston (1992) present a thorough discussion of the concept of bond duration.…”

“…Debt duration varies across countries. Cruces et al (2002) shows that, in 2000, the average debt duration in a sample of 27 emerging countries was equal to 4.77 years with a standard deviation of 1.52 years. Figure 4 illustrates how the mean and standard deviation of the spread observed the simulations increase monotonically with the average debt duration.…”

Valuation in Emerging Markets

“…Methodological problems arise when no liquid dollar denominated sovereign bonds of the right maturity are available in the respective emerging market and therefore no feasible reference bonds for both countries with a maturity corresponding to the project's horizon can be found. Using bonds with differing maturities will overvalue or undervalue long-term projects, as the time structure of default risks is hardly ever flat but upwards or downwards sloping (Cruces et al, 2002). In addition, country risks are not totally systematic risks, as stock returns in the developing and developed world are not perfectly correlated.…”

A New Taxonomy of Country Performance and Risk Based on Economic and Technological Indicators

“…Any errors are the sole responsibility of the author. JOURNAL OF APPLIED ECONOMICS 30 scenario of the markets, uncertain for nations and international investors alike, it is essential to measure and evaluate country performance and risk (Merton 1974;Cruces et al 2002;Nath 2004;Ortiz and Rodríguez 2002). Country assessment is important because it also provides information on economic instability, probability of default (Balkan 1992) and so on.…”