Cost of Capital: The Downside-Risk Approach

Abstract

This note describes the downside risk approach to estimating the cost of equity in emerging markets and contains an example. Based on paper: Javier Estrada, The Cost of Equity in Emerging Markets: A Downside Risk Approach, Emerging Markets Qtly (Fall 2000). Excerpt UVA-F-1394 Rev. Nov. 8, 2013 COST OF CAPITAL: THE DOWNSIDE-RISK APPROACH Emerging Markets and CAPM CAPM is often the method of choice among practitioners for estimating the cost of equity for investment projects in developed economies. But for investment projects in emerging economies, CAPM tends to give estimates that are considered too low by experienced financial managers. Sometimes, CAPM estimates of the cost of equity for projects in emerging markets are even lower than those for comparable projects in developed economies. This observation calls into question whether the CAPM-based model is applicable in emerging markets. Conceptually, CAPM assumes fully integrated markets. Emerging markets are, at best, partially integrated. Stock returns in many emerging markets are only weakly correlated with stock returns in developed markets. In other words, emerging markets are often low or even negative beta markets relative to the U.S. equity market. If we maintain that beta is an appropriate measure of risk, many emerging markets would have low investment risks. . . .