Global risk factors and the cost of capital

C.G. Koedijk, M.A. van Dijk

Research output: Contribution to journalArticleAcademicpeer-review

8 Citations (Scopus)

Abstract

Analysis of 3,300 stocks from nine industrialized countries over the 1980–99 period indicates that whether the capital asset pricing model or some form of international capm is used makes little difference in the cost-of-capital estimate for most companies in most countries. The international capm yielded an estimate of the cost of equity capital that was significantly different from that of the domestic capm in only 4–5 percent of the sample companies. For the vast majority of companies, the domestic market factor is an adequate benchmark against which to measure an individual company's exposure to both global market and currency risk factors. International financial markets are becoming integrated; hence, global risk factors are increasingly important for portfolio selection and asset pricing. Recent research in the empirical finance literature confirms that global risk factors—notably, the global market portfolio and exchange rate risk—are indeed important determinants of asset returns. This research suggests that practitioners interested in estimating a company's cost of equity capital should use an international version of the capital asset pricing model (capm) that includes global market and currency risk factors. Recent survey evidence indicates, however, that the single-factor capm, in which the local market factor is the only priced risk factor, is still the dominant model used in practice.from a practical perspective, then, whether incorporating global risk factors would significantly alter cost-of-capital computations is of considerable importance. But empirical literature on the subject is virtually nonexistent. We report empirical evidence on the practical effects of incorporating global risk factors in cost-of-capital computations.we analyzed almost 3,300 stocks from nine industrialized countries over the 1980-99 period to discover whether the single-factor domestic capm provided a substantially different cost of capital than provided by two versions of the international capm—a single-factor icapm in which the global market factor is the only priced risk factor and a multifactor icapm that includes currency risk factors as well as the global market factor.we found that the choice of model does not make a difference if the domestic market factor effectively captures an individual company's exposure to the global risk factors. In the case of the single-factor icapm, our sample yielded an estimate of the cost of equity capital that was significantly different from that of the domestic capm for only approximately 4 percent of the companies. In the case of the multifactor icapm, the difference was significant for only 5 percent of the companies.the conclusion is that for the vast majority of companies, the domestic market factor is an adequate benchmark against which to measure an individual company's exposure to both global market and currency risk factors. Incorporating global risk factors into cost-of-capital estimations led to an adjustment of roughly 50 bps a year on average for the u.s. Sample and 70–100 bps a year for the other countries. Adjustments of this magnitude easily fall inside the confidence interval associated with actual cost-of-capital computations. Specifically for u.s. Companies, the change in the cost-of-capital estimate from using an icapm is so small that we can conclude that global risk factors do not really matter for computing the cost of capital of u.s. Companies.although empirical evidence indicates that security returns are more and more driven by industry factors than by country factors, we contend that the domestic capm is not likely to become redundant in the context of valuation and capital budgeting. This finding has important implications for financial analysts, because using a multifactor icapm for computations of the cost of capital can be cumbersome and estimating currency risk premiums and exposures is extraordinarily complicated. Our study reveals that for a large number of companies, practitioners can rely on the straightforward single-factor domestic capm for calculating the cost of equity capital.
Original languageEnglish
Pages (from-to)32-39
Number of pages8
JournalFinancial Analysts Journal
Volume60
Issue number2
DOIs
Publication statusPublished - 1 Jan 2004

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