The Term Structure of Country Risk and Valuation in Emerging Markets
32 Pages Posted: 30 Sep 2002
Date Written: August 12, 2002
The prevailing valuation technique in Emerging Markets adds the country risk to the discount rate in an ad-hoc manner. This practice does not account for the term structure of default risk. The mismatch between the duration of the project being valued and the duration of the measure of country risk used, such as 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. Even if the term structure of default risk were flat, this practice implies attenuating the covariance risk premium. Using sovereign bond data from five Emerging Markets, we estimate a model that captures most of the variation of expected collection at different horizons at one point in time. We show the mispricing errors that are likely to be incurred in practice and how our model can be used to avoid them.
Keywords: Emerging Economies, Cost of Capital, Default Risk
JEL Classification: G15, G31
Suggested Citation: Suggested Citation