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Quantification of the Operative Risk in the Cost of Capital

Author

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  • Florin Cristea
  • Vasile Ilie

Abstract

When looking at the Global economy and the quantification of the operative risk in the cost of capital, a necessary ingredient for a meaningful analysis is an assessment of the country`s integration into world capital markets. The international financial markets are progressively becoming one huge, integrated, global capital market, that is contributing to higher stock prices in developed as well as developing economies. If for example a market is segmented from the rest of the world, its exposure with a common world factor may have little or no ability to explain its expected return. Large companies visible enough to attract global investors, have a lower cost of capital and a greater equity value for two main reasons: first, because the risks of equity are shared among more investors with different portfolio exposures and hence a different “appetite†for bearing certain risks, equity market risk premiums should fall for all companies in countries with access to global markets. Second, when firms in countries with less-developed capital markets raise capital in the public markets of countries with highly developed markets, they get more than lower-cost capital; they also import at least aspects of the corporate governance systems that prevail in those markets. Besides reducing market risk premiums and improving corporate governance, globalization also affects the systematic risk, of individual companies. In global markets, the beta of a firm's equity depends on how the stock contributes to the volatility not of the home market portfolio, but of the world market portfolio. For companies with access to global capital markets whose profitability is tied more closely to the local than to the global economy, use of the traditional CAPM will overstate the cost of capital because risks that are not diversifiable within a national economy can be diversified by holding a global portfolio.

Suggested Citation

  • Florin Cristea & Vasile Ilie, 2018. "Quantification of the Operative Risk in the Cost of Capital," Romanian Economic Journal, Department of International Business and Economics from the Academy of Economic Studies Bucharest, vol. 21(70), pages 94-113, December.
  • Handle: RePEc:rej:journl:v:21:y:2018:i:70:p:94-113
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    References listed on IDEAS

    as
    1. Mr. Udaibir S Das & Jay Surti & Mr. Faisal Ahmed & Mr. Michael G. Papaioannou & Mr. Guilherme Pedras, 2010. "Managing Public Debt and Its Financial Stability Implications," IMF Working Papers 2010/280, International Monetary Fund.
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    More about this item

    Keywords

    Romania; cost of capital; market portfolio; equity value;
    All these keywords.

    JEL classification:

    • B22 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Macroeconomics
    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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