Quantifying Latin American Firms' Exposure to External Factors

Universidad del CEMA Documento de Trabajo No. 282

32 Pages Posted: 3 Sep 2007

See all articles by Sergio Pernice

Sergio Pernice

University of CEMA

Mariano Fernández

Universidad del CEMA

María Alegre

Universidad del CEMA

Date Written: December 2004

Abstract

This is the last of a series of three working papers analyzing the basic characteristics of the economic environment in which Latin American firms operate and the optimal design of incentive programs compatible with such environment. Executive pay-for-performance compensation schemes are usually based on stock returns. However, stock returns change in response to forces beyond management control (e.g., market crushes). The economic environment in which Latin American firms operate is highly unstable, which means that this is a very important limitation for Latin American firms.

In the present paper, we present a procedure to decompose variability in stock returns in order to identify and measure components that respond to external factors beyond management control. For this, we have created indices that capture statistically the external influences that affect stock returns. We show how such indices can be used to construct a risk profile that allows management to know to what extent observed outcomes depend on external factors, versus their own actions. In addition, these indices can be used as a basis to develop indexed options": financial instruments designed to factor out the effects of external risks, making it possible for executives to be evaluated only on the basis of the value they generate. We show that these indices can be developed out of purely local information, but that the solutions tend to be moderately unstable, which implies that compensation instruments developed with this methodology should be of relatively short maturity.

Suggested Citation

Pernice, Sergio and Fernández, Mariano and Alegre, María, Quantifying Latin American Firms' Exposure to External Factors (December 2004). Universidad del CEMA Documento de Trabajo No. 282, Available at SSRN: https://ssrn.com/abstract=1009282 or http://dx.doi.org/10.2139/ssrn.1009282

Sergio Pernice (Contact Author)

University of CEMA ( email )

Department of Finance Cordoba 637 - Piso 3
1054 Buenos Aires
Argentina
4314-1304 (Phone)
4314-1654 (Fax)

Mariano Fernández

Universidad del CEMA ( email )

1054 Buenos Aires
Argentina

María Alegre

Universidad del CEMA ( email )

1054 Buenos Aires
Argentina

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