Cost of capital for emerging market investments

Abstract

Valuation of cross-border investments is increasingly becoming important with the recent escalation in cross-border transactions in the global economy. Developing economies like India, China, Brazil and east-Asian countries; are becoming attractive destinations for foreign investments for multi-national firms in developed economies. While the CAPM gives a framework to compute cost of capital for any investment, additional risk factors need to be considered for investments in emerging markets owing to the specific conditions prevailing in these economies. In this project, we aim to develop a framework for computing cost of capital for project investments in emerging economies. We begin by understanding the need and importance of our work, followed by a definition of our objectives. In our literature review, we give a brief overview of the related work done in this field. Here, we describe some of the existing models which take into account the country risk premium for investments in emerging economies. It is followed by a description of two most important risks faced by any cross-border investment, Country risk and Foreign exchange risk. We also discuss liquidity and regulatory risks which are characteristic of developing economies. Pertinent questions regarding the relevance of country risk and its computation are handled next in our report. We describe our new proposed model to compute cost of capital for an investment in emerging markets which is followed by a detailed description of our analysis and empirical study.