Decoding Currency Risk: Pictures of Global Risk - Part IV

In my last three posts, I have looked at country risk, starting with measures of that risk and then moving on to valuing and pricing that risk . You may find it strange that I have not mentioned currency risk in any of these posts on country risk, but in this one, I hope to finish this series by looking first at how currency choices affect value and then at the dynamics of currency risk.

Currency Consistency

A fundamental tenet in valuation is that you have to match the currency in which you estimate your cash flows with the currency that you estimate the discount rate that you use to discount those cash flows. Stripped down to basics, the only reason that the currency in which you choose to do your analysis matters is that different currencies have different expected inflation rates embedded in them. Those differences in expected inflation affect both our estimates of expected cash flows and discount rates. When working with a high inflation currency, we should therefore expect to see higher discount rates and higher cash flows and with a lower inflation currency, both discount rates and cash flows will be lower. In fact, we could choose to remove inflation entirely out of the process by using real cash flows and a real discount rate.

Pricing Country Risk - Pictures of Global Risk - Part III

In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post. In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions.

Pricing Country Risk

If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (PE, Price to Book, EV to EBITDA ) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the PE ratios (or any other multiple) will be lower in riskier countries than in safer ones.