734 CHAPTER 19. SETTING THE COST OF INTERNATIONAL CAPITAL
Table 19.3:Rules for the Capital-Budgeting Process: OverviewCoCa model currency of cal-culations- Foreign investments:
- home and host financially integrated incapm fc&hc
- home and host financially segmented
- home country part of larger financial market incapm hconly
- home country totally isolated capm hconly
- domestic investments
- home country part of larger financial market incapm n.a.
- home country totally isolated capm n.a.
Example 19.13
At the time of writing, the Chilean stock market remains strongly segmented from
the rest of the world. If a Chilean firm makes an investment in Chile, the firm will
estimate the beta by regressing returns from a portfolio of stocks in the same indus-
try on the Chilean stock market index. Note that the returns from this investment
are likely to be strongly correlated with the Chilean market index because there
are important common factors, like the business cycle or interest rates, that affect
all Chilean firms in similar ways. Thus, the investment is relatively risky for an
Chilean firm. But the same project may be low-risk from the point of view of, say,
an Austrian firm. The reason is that, because the Chilean economy is only loosely
connected to North-America, Europe and Asia, the returns from the Chilean project
will not be highly correlated with the returns on the typical world investor’s port-
folio, which is strongly diversified internationally. So the investment adds little to
the risk of an international portfolio, but much more to the risk of a purely Chilean
portfolio.
Note that segmentation of the home-country and the host-country capital mar-
kets does not mean that each market is a single-country market. The shareholders
of the Austrian firm are likely to live in many different countries, and they all have
access to non-Austrian shares, too. Thus, it is appropriate for the Austrian firm
to set its cost of capital using an international model, that is, using the “world”
market portfolio as a proxy for the true benchmark relevant to its shareholders.
19.4.2 Estimating the Risk of a Project
The market risk and the exchange risk exposures are defined as the slope coeffi-
cients in the regression ofj’s return on the world market return and all relevant
exchange rate changes. Estimates obtained from time series of past data are subject
to substantial estimation errors, stemming from pure sample-specific coincidences.