Equity Risk Premium Analysis for Brazil

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Questions and Answers

What is the total Equity Risk Premium (ERP) for Brazil using the country risk premium and the base equity risk premium?

7.88% (correct)

1.32%

4.60%

3.28%

What is the central idea behind the equity volatility based approach for estimating the total ERP?

It relies on the difference between a country's economic growth and that of the United States.

It averages several macroeconomic indicators to derive a risk factor.

It uses analyst forecasts of future earnings growth.

It uses the standard deviations of equity market returns of the emerging market and a base market, usually the U.S. (correct)

Given a US equity risk premium of 5.94%, a Brazilian equity standard deviation of 30%, and a US equity standard deviation of 18%, what is the total equity risk premium using the volatility based approach?

9.90% (correct)

4.60%

7.67%

5.94%

Using the volatility-based approach, what's the Country Equity Risk Premium for Brazil given a total equity risk premium of 7.67% and a base equity risk premium of 4.60%?

3.07% (B) Signup and view all the answers

The melded approach suggests that equity spreads are expected to be debt spreads due to .

higher than; the greater volatility of equity markets (C) Signup and view all the answers

What is a key factor that can influence the historical risk premium?

The time frame considered, the government bond rates used, and the averaging method applied. (A) Signup and view all the answers

Why can using the historical data from the US equity market lead to a sampling bias?

Because the US economy and equity markets have been historically more successful compared to others. (C) Signup and view all the answers

A standard deviation of 20% in annual stock returns over 90 years results in a standard error of premium of approximately?

2.1% (D) Signup and view all the answers

The country equity risk premium is often set equal to a default spread. Which of the following is NOT a method mentioned to derive that spread?

The average inflation rate of the country for the last decade. (B) Signup and view all the answers

What was the approximate default spread for Brazil's dollar-denominated bond in January 2024?

1.817% (B) Signup and view all the answers

What was the approximate sovereign CDS spread for Brazil in January 2024, after adjusting for the US CDS spread?

1.81% (D) Signup and view all the answers

In January 2024, the default spread for a Ba2 rated sovereign was approximately?

3.28% (D) Signup and view all the answers

If a mature market premium is 4.60% and a country's default spread is 2.0%, what is the total equity risk premium for that country?

6.6% (A) Signup and view all the answers

What does the slope of the regression line correspond to in the context of stock analysis?

The beta of the stock (B) Signup and view all the answers

Which of these is considered a problem with using beta as a measure of risk?

It has a high standard error (D) Signup and view all the answers

According to the provided content, what is a drawback of using historical data for beta calculation?

It may not reflect the firm's current business mix or leverage (C) Signup and view all the answers

Which measure is most useful for capturing all risk, not just market risk, when assessing relative risk?

Relative Standard Deviation (C) Signup and view all the answers

What is the main characteristic of proxy models for risk analysis?

They use historical data on market capitalization and add other variables (A) Signup and view all the answers

What does the CAPM plus model do in the context of risk analysis?

It starts with traditional CAPM and adds other premiums for proxies (A) Signup and view all the answers

What is one way to measure relative risk that does not rely on market priced measures?

Accounting earnings volatility (A) Signup and view all the answers

What is a key characteristic of GameStop (GME) during 2019 and 2020 as per the slides?

It was an extraordinarily volatile stock due to a battle between short sellers and long investors. (C) Signup and view all the answers

Based on the provided data, what does the regression coefficient of 2.0030 in the Embratel equation signify?

An increase of 2.0030% in Embratel's return for every 1% increase in C-Bond returns. (D) Signup and view all the answers

In the context of active country risk management, what is implied by the phrase 'firms might be able to actively manage their country risk exposures'?

Firms use tools and strategies to limit potential losses due to country-specific risks. (D) Signup and view all the answers

Using the provided regression data, which statement best describes the relative sensitivity of Embraer and Embratel to changes in the C-Bond return?

Embratel is approximately 7.5 times more sensitive to changes in the C-Bond return than Embraer. (D) Signup and view all the answers

What is the significance of a beta of 1.07 for Embraer, in the provided content?

Embraer's returns are 1.07 times more volatile than the market. (D) Signup and view all the answers

Given the regression equation for Embraer, what is the intercept of 0.0195 in the equation?

The theoretical expected return of Embraer when the C-Bond return is zero. (A) Signup and view all the answers

If the return on the C-Bond is 0, what is the expected return of Embratel based on the regression data?

An expected return of approximately -3.08% (D) Signup and view all the answers

If Embraer's beta is 1.07 and the risk-free rate is 4%, what would be the correct calculation to estimate the cost of equity using this information?

This data is not enough to calculate the cost of equity (D) Signup and view all the answers

What does the graph showing 'Embraer versus C Bond' illustrate?

The volatility of returns for Embraer relative to the C-Bond. (B) Signup and view all the answers

What is the effect of increasing the number of firms in a sample when calculating the standard error of a bottom-up beta?

The standard error decreases. (D) Signup and view all the answers

Which of these situations are appropriate for using a bottom-up beta?

When the company is a private business. (B) Signup and view all the answers

According to the information provided, what is the unlevered beta of the Metals & Mining business of VALE?

0.86 (C) Signup and view all the answers

If there was a firm in the peer group of Iron Ore business of VALE, and the unlevered Beta was 0.90, what would happen to the bottom up Beta for Iron Ore business, if we only used its information?

It would increase the bottom-up Beta of Iron Ore. (B) Signup and view all the answers

What is the main factor that causes the difference between the unlevered beta and the levered beta?

The debt-to-equity ratio. (A) Signup and view all the answers

Using the information provided, what is the levered beta for Embraer's Aerospace business?

1.07 (A) Signup and view all the answers

Why might using an unlevered beta from U.S. and European aerospace companies be a concern when calculating the beta for a Brazilian aerospace company?

There might be differences in market risk and company's operations, and thus in their betas. (A) Signup and view all the answers

When do regression betas typically reflect?

The past market behavior. (B) Signup and view all the answers

When calculating debt ratios, what is the primary difference between the gross debt and net debt approaches?

Gross debt uses total debt, while net debt subtracts cash from total debt. (C) Signup and view all the answers

How does using net debt instead of gross debt typically impact a company's levered beta?

Net debt tends to decrease the levered beta, indicating less financial risk. (C) Signup and view all the answers

According to the content, how does the cost of equity vary when using a net debt levered beta versus a gross debt levered beta?

The cost of equity is lower when using the net debt levered beta, relative to using the gross debt levered beta. (B) Signup and view all the answers

What is the typical source for the risk-free rate when calculating the cost of equity?

The yield on a government treasury bond with a maturity that matches the investment horizon (A) Signup and view all the answers

In the cost of equity calculation, what is the role of the equity risk premium?

It represents the additional return investors expect for the risk of investing in stocks over the risk-free rate. (A) Signup and view all the answers

How should the currency of the risk-free rate and risk premium relate to the cash flows being analyzed in the cost of equity calculation?

All the three values must be in the same currency. (A) Signup and view all the answers

What does the cost of debt primarily reflect?

A combination of the company's default risk and prevailing market interest rates. (A) Signup and view all the answers

How is the levered beta typically estimated in practice?

Using a bottom-up beta, derived from comparable firms in the same business, adjusted by the firm’s own financial leverage. (A) Signup and view all the answers

Study Notes

Discount Rates

Discount rates are crucial in valuation.
A risk-free investment has an actual return equal to the expected return, with no variance.
No default risk and no reinvestment risk are required for a risk-free investment.

Risk-Free Rate

Time horizon influences risk-free rates in valuation.
Risk-free rates differ by currency.
Not all government securities are risk-free; some governments face default risk.

Risk-Free Rate in US Dollars

For valuing a company in US dollars, the appropriate risk-free rate is dependent upon the cash flow timeframe.
Options include three-month Treasury bill rate (4.42%), ten-year Treasury bond rate (3.88%), thirty-year Treasury bond rate (3.97%), and TIPS rate (1.53%).
Implicit assumptions about US Treasury need to be considered when using treasury numbers.

Risk-Free Rate in Euros

Graph showing government bond rates for 10-year Euro bonds across different European countries.

Risk-Free Rate in Indian Rupees

The Indian government's 10-year Rupee bonds had a yield to maturity of ~7.18% on January 1, 2024.
In early 2024, the typical default spread for Baa3-rated country bonds was 2.39%.
The risk-free rate in Indian Rupees can be calculated using the yield to maturity of the 10-year bond and the default spread.

Sovereign Default Spread

Three methods for determining sovereign default spread include analyzing sovereign dollar/Euro bonds, CDS spreads, and sovereign rating-based spread.

Approach 1: Default Spread from Government Bonds

Tables showing default spreads for various countries using US bond rates as the risk-free rate.

Approach 2: CDS Spreads

Tables providing CDS spreads for various countries as of January 2024.

Approach 3: Typical Default Spreads

Tables of typical default spreads based on S&P and Moody's sovereign ratings.

Getting to a Risk-Free Rate in Brazilian Reais

Three methods to determine the risk-free rate in Brazilian Reais for January 1, 2024 when the Brazilian government bond rate was 10.35%.

A Real Risk-Free Rate

Sometimes, a real risk-free rate (in real terms) is preferred over a nominal risk-free rate.
Treasury-indexed securities provide a guaranteed real return.
A 10-year indexed Treasury bond yield of 1.80% in January 2024.

Why Do Risk-Free Rates Vary Across Currencies?

Chart showing risk-free rate variations across different currencies (in January 2024) based on government bond rates.

US Treasuries Across Time

Graph demonstrating US treasury changes over time (showing 3-month, 2-year, 10-year, and 30-year maturities) from February 14, 2020, to August 14, 2020.

Risk-Free Rate: Don't Have or Don't Trust the Government Bond Rate?

Formula for deriving a risk-free rate by using the differential inflation rate.
The formula considers inflation rates in the base currency (e.g., US dollars) and the currency of interest.

One More Test on Risk-Free Rates

A 10-year treasury bond rate of 1.51% in January 2022.
Options for adjusting the risk-free rate in a situation where it is considered too low.

Some Perspective on Risk-Free Rates

Graph showing T. Bond rate, inflation rate, and Real GDP growth rate from 1954 to 2023.

Negative Interest Rates?

Discussion regarding negative interest rates and how to handle them in valuations, as well as how low rates can go.

The Equity Risk Premium

The historical premium is the premium that stocks have earned over risk-free securities.
The historical equity risk premiums, are sensitive to timeframe.
Different measures of risk premiums (arithmetic or geometric averages) can be used.
Historical Premiums are noisy and subject to survivorship bias.

The Country Default Spread

Calculation methods for country equity risk premium based on dollar-based bonds, sovereign CDS spreads and country rating-based spreads.
Approach to add a country risk premium to a market premium.

An Equity Volatility-Based Approach to Estimating the Total ERP

Estimate the total equity risk premium based on volatility.
Calculation using the volatility of the US market as the base and the emerging market in question.

A Melded Approach Estimating Country Risk Premium

Combining country ratings and volatility.
A formula and example for the approach.

A Template for Estimating the ERP

Procedures to estimate ERP.
Check sovereign rating.
Determine if there is no risk score.

ERP: January 2024

Table presenting country ratings, calculated country risk premiums, and corresponding equity risk premiums for January 2024.

From Country Equity Risk Premiums to Corporate Equity Risk Premiums

Three distinct approaches to determining the appropriate corporate equity risk premiums according to country risk exposures.

Estimating Country Risk Premium Exposure

Chart showing the interaction between a company’s country of incorporation and its operations across different countries to estimate the country risk premium
A formula for determining the overall risk, taking country and operation factors into consideration.

Operation Based CRP: Single Versus Multiple Emerging Markets

Examples demonstrating the computation of country risk premium based on operation factors for companies like Embraer and Ambev.

Extending to a Multinational: Regional Breakdown

Breakdown of Coca-Cola’s revenue by region and corresponding ERP in 2012.
Highlights of considerations for international business operations.

Two Problems with These Approaches

Cautionary note regarding solely relying on revenue figures for determining risk exposures.
A note regarding issues with beta-based approaches in assessing country-specific risk premium exposure.

A Production-Based ERP: Royal Dutch Shell in 2015

Detailed breakdown of Royal Dutch Shell’s oil and gas production by country for 2015, indicating the percentage of total production and ERP for each country.

Estimate a Lambda for Country Risk

Considerations for estimating lambda to assess the impact of country risk on a company’s operations.
Discusses informational components in the country credit risk estimate.

A Revenue-Based Lambda

Computation of lambda using the percentage of domestic revenues relative to the average firm in the same sector.
Firm-specific operational analysis to determine a company’s relative country risk exposure component.

A Price/Return Based Lambda

Charts demonstrating the correlations between realized returns of Embraer stocks, and those of comparable publicly traded companies, providing a price/return based method for determining a lambda.

Estimating a US Dollar Cost of Equity for Embraer - September 2004

Five different approaches to estimate the cost of equity for Embraer in September 2004.
These approaches account for factors like beta, location risk premium, operational risk premium.

Valuing Emerging Market Companies with Significant Exposure in Developed Markets

A conventional practice in investment banking for estimating cost of equity for emerging markets is assessing exposure to country risk.
Consequences of overlooking emerging market exposures are explored.
Opportunity to generate profit from such misvaluation is discussed.

Implied Equity Premiums

Explaining how to calculate implied equity premiums using stock price and expected cash flows.

Equity Risk Premium: January 2020

Step-by-step calculation for implied equity premium based on actual cash flows and expected growth.

And In 2020…COVID Effects

Graph illustrating the impact of the COVID-19 pandemic on the implied equity risk premium of the S&P 500 during 2019-2020.

An Updated Estimate: ERP in 2024

Calculation of implied equity risk premium (ERP) for 2024, providing details on expected earnings/cash flow growth over 5 years.

Implied Premiums in the US: 1960-2023

Implied equity risk premium for the US equity market from 1960-2023.

Implied Premium Versus Risk-Free Rate

Graph comparing implied ERP and risk-free rate for the years 1960-2023.

Equity Risk Premiums and Bond Default Spreads

Graph depicting the interplay between equity risk premiums and bond default spreads since 1960.

Equity Risk Premiums and Cap Rates (Real Estate)

Graph showcasing equity risk premiums, bond spreads, and real estate risk premiums from 1980 to 2023.

Why Implied Premiums Matter?

Importance of implied premiums, especially in corporate finance departments and for valuing stocks.
Illustrative examples showcasing consequences of using incorrect premiums while evaluating stocks.

Which Equity Risk Premium Should You Use?

Table summarizing correlations between various predictors of implied equity risk premium & actual stock returns.

An ERP for the Sensex

Procedure for calculating the ERP based on market parameters, particularly the Sensex index.

The Evolution of Emerging Market Risk

Comprehensive table highlighting the evolution of emerging market risk factors from 2004 to 2023, showing various metrics like PBV, PBV/ROE, US T-bond rate, Growth, Cost of Equity, etc. for developed and emerging markets.

Relative Risk Measures

Discussion regarding relative risk measures.

The CAPM Beta: The Most Used (And Misused) Risk Measure

Procedures and limitations in the commonly used market regression approach for estimating beta.

Unreliable, When It Looks Bad..

Illustration of a method where beta estimates are inaccurate.

Or When It Looks Good..

Graphs demonstrating a more accurate risk estimation methodology.

One Slice of History…

Detailed information on the volatility of GME stock throughout 2019-2020, highlighting an exceptionally volatile stock from the period.

And Subject to Game Playing

Graphs presenting a summary of data points for a firm (Bombardier Inc.) and an associated index (S&P 500 index).

Measuring Relative Risk: You Don't Like Betas or Modern Portfolio Theory? No Problem.

Provides various approaches to estimating the relative risk of stocks in addition to the standard beta and their advantages.

Don't Like the Price-Based Approach…

Detailed analysis on various methods for calculating relative risk other than using market prices.

Determinants of Betas & Relative Risk

Factors determining equity beta, such as the nature of a company's products, operating, and financial leverage.

In a Perfect World... We Would Estimate the Beta of a Firm by Doing the Following

Step-by-step outline of the process to determine accurate beta for companies in an ideal scenario.

Adjusting for Operating Leverage...

Explanation of how to adjust for operating leverage when calculating beta, and the potential issues with securing appropriate data.

Adjusting for Financial Leverage...

Different methods for adjusting equity beta based on the financial leverage (debt-equity ratio) of the firm and a consideration of the tax benefits of debt.

Bottom-Up Betas

Step-by-step process for deriving bottom-up betas.

Why Bottom-Up Betas?

Demonstrating the advantages of bottom-up betas, such as reduced standard error, ability to incorporate more current data, and overcoming reliance on historical price data.

Estimating Bottom Up Betas & Costs of Equity

Tables containing data points pertaining to the bottom-up method for deriving betas across various businesses.

Embraer's Bottom-Up Beta

Calculation details for Embraer's beta as derived by the bottom-up method.

Gross Debt Versus Net Debt Approaches

Comparison of using gross debt to net debt in calculating debt ratios, and the consequence on cost of equity.

The Cost of Equity: A Recap

Summary of the different methods for calculating a company's cost of equity.

Cost of Debt

Explanation of how to calculate the cost of debt for a company.

Estimating Synthetic Ratings

Simple methods for estimating synthetic ratings based on interest coverage ratios.

Interest Coverage Ratios, Ratings and Default Spreads: 2004

Table displaying interest coverage ratios, corresponding ratings for corporate bonds, and calculated default spreads for 2004.

Cost of Debt Computations

Example computation of the cost of debt for Embraer in 2004.
Description of how to estimate the cost of equity and debt for a firm.

If You Had To Do It…Converting a Dollar Cost of Capital to a Nominal Real Cost of Capital

Two different approaches to convert a dollar-based cost of capital to a nominal real cost of capital.

Dealing with Hybrids and Preferred Stock

Explanation on how to treat hybrid securities (like convertible bonds) and preferred stock when evaluating a company's cost of capital.

Decomposing a Convertible Bond...

Step-by-step demonstration of how to analyze a convertible bond by separating it into its components of debt and equity.

Recaping the Cost of Capital

Summary of important elements to consider in determining the cost of capital for a firm.

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Description

This quiz explores the calculation of the total Equity Risk Premium (ERP) for Brazil using various approaches such as country risk premium and volatility-based methods. It also examines the influencing factors and risks associated with equity markets. Test your understanding of these concepts and their applications in financial analysis.