Sovereign Risk and Investing in Emerging Markets
19 Pages Posted: 1 Oct 2010
Date Written: September 30, 2010
The traditional approach to evaluating investments in emerging economies has been to add a political default premium to the discount rate used to evaluate the investment’s net present value. This approach contrasts with the textbook approach that accounts for political risk by adjusting expected cash flows. In this paper we discuss the notion of a term structure of default risk and identify the types of valuation errors that occur if cumulative survival rates do not decline exponentially (which is implicit in the use of a constant sovereign default adjustment to the discount rate). Moreover, we point out the importance of structuring the investment project terms so as to minimize the risk of expropriation.
Keywords: Sovereign risk, Emerging markets, Investment Analysis
JEL Classification: G15, G30, G31
Suggested Citation: Suggested Citation