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The Term Structure of Country Risk and Valuation in Emerging Markets

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Author Info

  • Juan Jose Cruces

    (Department of Economics, Universidad de San Andres)

  • Marcos Buscaglia

    (IAE)

  • Joaquin Alonso

    (Mercado Abierto S.A.)

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    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.

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    File URL: ftp://webacademicos.udesa.edu.ar/pub/econ/doc46.pdf
    File Function: Revised version, 2002
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    Bibliographic Info

    Paper provided by Universidad de San Andres, Departamento de Economia in its series Working Papers with number 46.

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    Length: 27 pages
    Date of creation: Jan 2002
    Date of revision: Apr 2002
    Handle: RePEc:sad:wpaper:46

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    Related research

    Keywords: Emerging Economies; Cost of Capital; Default Risk;

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    References

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    1. Harvey, Campbell R, 1995. "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 773-816.
    2. Errunza, Vihang & Losq, Etienne, 1985. " International Asset Pricing under Mild Segmentation: Theory and Test," Journal of Finance, American Finance Association, vol. 40(1), pages 105-24, March.
    3. Neumeyer, Pablo Andrés & Perri, Fabrizio, 2004. "Business Cycles in Emerging Economies: The Role of Interest Rates," CEPR Discussion Papers 4482, C.E.P.R. Discussion Papers.
    4. John J. Merrick Jr., 1999. "Crisis Dynamics of Implied Default Recovery Ratios: Evidence From Russia and Argentina," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-052, New York University, Leonard N. Stern School of Business-.
    5. Stephen Godfrey & Ramon Espinosa, 1996. "A Practical Approach To Calculating Costs Of Equity For Investments In Emerging Markets," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(3), pages 80-90.
    6. Bekaert, Geert & Harvey, Campbell R. & Lumsdaine, Robin L., 2002. "Dating the integration of world equity markets," Journal of Financial Economics, Elsevier, vol. 65(2), pages 203-247, August.
    7. Tom Keck & Eric Levengood & AL Longfield, 1998. "Using Discounted Cash Flow Analysis In An International Setting: A Survey Of Issues In Modeling The Cost Of Capital," Journal of Applied Corporate Finance, Morgan Stanley, vol. 11(3), pages 82-99.
    8. Chen, Houng-Yhi, 1967. "Valuation Under Uncertainty," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 2(03), pages 313-325, September.
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    Citations

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    Cited by:
    1. Serafín Frache & Gabriel Katz, 2004. "Estimating a Risky Term Structure of Uruguayan Sovereign Bonds," Documentos de Trabajo (working papers) 0304, Department of Economics - dECON.
    2. Marcos A. Buscaglia, 2003. "The Political-Economy of Argentina’s Debacle," William Davidson Institute Working Papers Series 2003-594, William Davidson Institute at the University of Michigan.
    3. Hatchondo, Juan Carlos & Martinez, Leonardo & Sosa Padilla, César, 2014. "Voluntary sovereign debt exchanges," Journal of Monetary Economics, Elsevier, vol. 61(C), pages 32-50.
    4. Leonardo Martinez & Juan Hatchondo & Javier Bianchi, 2012. "Sovereign defaults and optimal reserves management," 2012 Meeting Papers 1125, Society for Economic Dynamics.
    5. Juan Carlos Hatchondo & Leonardo Martinez, 2009. "Long-duration bonds and sovereign defaults," Working Paper 08-02, Federal Reserve Bank of Richmond.
    6. Javier Bianchi & Juan Carlos Hatchondo, 2013. "International reserves and rollover risk," Globalization and Monetary Policy Institute Working Paper 151, Federal Reserve Bank of Dallas.
    7. Marcos Buscaglia, 2004. "The Political Economy of Argentina's Debacle," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 7(1), pages 43-65.
    8. Leonardo Martinez & Juan Carlos Hatchondo & Cesar Sosa Padilla, 2011. "Debt Dilution and Sovereign Default Risk," IMF Working Papers 11/70, International Monetary Fund.

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