Most investors would accept the general proposition that different companies in a market should have different exposures to country risk. But what are the determinants of this exposure? In this section, we will consider the factors that determine lambdas.

Revenue Sources

The most obvious determinant of a company’s risk exposure to country risk is how much of the revenues it derives from the country. A company that derives 30% of its revenues from Brazil should be less exposed to Brazilian country risk than a company that derives 70% of its revenues from Brazil. Note, though, that this then opens up the possibility that a company can be exposed to the risk in many countries.

Thus, the company that derives only 30% of its revenues from Brazil may derive its remaining revenues from Argentina and Venezuela, exposing it to country risk in those countries. Extending this argument to multinationals, we would argue that companies like Coca Cola and Nestle can have substantial exposure to country risk because so much of their revenues come from emerging markets.

Production Facilities

A company can be exposed to country risk, even if it derives no revenues from that country, if its production facilities are in that country. After all, political and economic turmoil in the country can throw off production schedules and affect the company’s profits.

Companies that can move their production facilities elsewhere can spread their risk across several countries, but the problem is exaggerated for those companies that cannot move their production facilities. Consider the case of mining companies. An African gold mining company may export all of its production but it will face substantial country risk exposure because its mines are not moveable.

Risk Management

Companies that would otherwise be exposed to substantial country risk may be able to reduce this exposure by buying insurance against specific (unpleasant) contingencies and by using derivatives. A company that uses risk management products should have a lower exposure to country risk – a lower lambda – than an otherwise similar company that does not use these products. Since a lower lambda will reduce the cost of equity and capital, why would a company choose not to manage risk?

The answer lies in the fact that risk management is not costless. Insurance costs money and will reduce the margins and profits of any company that uses it. Futures contracts may be less expensive but companies that use them lose upside potential while protecting against downside risk. A gold mining company that uses futures contracts to hedge against gold pricing risk will be protected from an earnings decline if gold prices go down but will have to give up higher earnings if gold prices go up.

Data Constraints

In practical terms, few would argue with the notion that a company’s exposure to country risk should be a function of a number of variables including the three listed above – where revenues originate, where production facilities are located and the use of risk management products. Before we start listing off more variables, we should be careful to note that much of this information is not publicly available.

Even with the three variables listed above, only one – revenue origins – is accessible for most companies in emerging markets. A few firms do provide information about their production facilities and very few provide details of the extent of risk management. It is possible that managers within a firm and consultants who are allowed access to internal records can come up with sophisticated measures of lambda for firms that incorporate more information about the firm. Investors have access to far less information and therefore have to settle for less ambitious measure of lambda.

Measuring Lambda

The lambda of a company can be estimated using one of three variables. The first and simplest measure is based entirely on where a company generates its revenues. The second measure is based upon accounting earnings in the most recent period and the variation in these earnings over time. The third measure uses stock prices, akin to conventional beta estimates, to estimate company risk exposure.

Revenue

In the last section, we argued that a company that derives a smaller proportion of its revenues from a market should be less exposed to country risk. But how do we go from this statement to an actual measure of lambda? Given the constraint that the average lambda across all stocks has to be one (some one has to bear the country risk), we cannot use the percentage of revenues that a company gets from a market as lambda.

We can, however, scale this measure by dividing it by the percent of revenues that the average company in the market gets from the country to derive a lambda. Lambdaj = % of Revenues in country for company j/ % of revenues for average company Consider the two large and widely followed Brazilian companies – Embraer, an aerospace company that manufactures and sells aircraft to many of the world’s leading airlines and Embratel, the Brazilian telecommunications giant. In 2002, Embraer generated only 3% of its revenues in Brazil, whereas the average company in the market obtained 85% of its revenues in Brazil. Using the measure suggested above, the lambda for Embraer would be:

LambdaEmbraer = 3%/ 85% = 0.04

In contrast, Embratel generated 95% of its revenues from Brazil, giving it a lambda of

LambdaEmbraer = 95%/ 85% = 1.12

Following up, Embratel is far more exposed to country risk than Embraer and will have a much higher cost of equity. To use this approach, we need to estimate both the percent of revenues for the firm in question and for the average firm in the market.

While the former may be simple to obtain, estimating the latter can be a time consuming exercise. One simple solution is to use data that is publicly available on how much of a country’s gross domestic product comes from exports. In table 2, we list the percentage of the GDP that comes from exports by region of the world and use it to compute the percent of GDP that is domestically directed.

According to the World Bank data in this table, Brazil got 23.2% of its GDP from exports in 2001. If we assume that this is an approximation of export revenues for the average firm, the average firm can be assumed to generate 76.8% of its revenues domestically. Using this value would yield slightly higher betas for both Embraer and Embratel.

 

Prof. Aswath Damodaran

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