International Finance and Accounting Handbook

of the factors that drive equity risk—the stability of a country’s currency, its budget
and trade balances, and its political stability, for instance^6 The other advantage of rat-
ings is that they come with default spreads over the U.S. Treasury bond. For instance,
Exhibit 9.2 summarizes the ratings and default spreads for Latin American countries
in June 2000. The market spreads measure the difference between dollar-denomi-
nated bonds issued by the country and the U.S. Treasury bond rate. While this is a
market rate and reflects current expectations, country bond spreads are extremely
volatile and can shift significantly from day to day. To counter this volatility, we have
estimated typical spreads by averaging the default spreads of all countries in the
world with the specified rating over and above the appropriate riskless rate. These
spreads tend to be less volatile and more reliable for long-term analysis.
Analysts who use default spreads as measures of country risk typically add them
on to both the cost of equity and debt of every company traded in that country. For
instance, the cost of equity for a Brazilian company, estimated in U.S. dollars, will
be 4.83% higher than the cost of equity of an otherwise similar U.S. company. If we
assume that the risk premium for the United States and other mature equity markets
is 5.51%, the cost of equity for an average Brazilian company can be estimated as
follows (with a U.S. Treasury bond rate of 5% and a beta of 1.2).

5%1.2 1 5.51% 2 4.83%
16.34%

Cost of equity
Risk-free rateBeta * 1 U.S. Risk premium 2 Default spread

9 • 10 VALUATION IN EMERGING MARKETS

Country Ratinga Typical Spreadb Market Spreadc

Argentina B1 450 433

Bolivia B1 450 469

Brazil B2 550 483

Colombia Ba2 300 291

Ecuador Caa2 750 727

Guatemala Ba2 300 331

Honduras B2 550 537

Mexico Baa3 145 152

Paraguay B2 550 581

Peru Ba3 400 426

Uruguay Baa3 145 174

Venezuela B2 550 571

aRatings are foreign currency ratings from Moody’s.

bTypical spreads are estimated by looking at the default spreads on bonds issued by all

countries with this rating and are over and above a riskless rate (U.S. treasury or German

Euro rate).

cMarket spread measures the spread difference between dollar-denominated bonds issued

by this country and the U.S. treasury bond rate.

Exhibit 9.2. Ratings and Default Spreads: Latin America.

(^6) The process by which country ratings are obtained is explained on the S&P Web site at http://www.rat-
ings.standardpoor.com/criteria/index.htm.