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What Is International Cost of Capital?

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  • Written By: Ray Hawk
  • Edited By: E. E. Hubbard
  • Last Modified Date: 22 November 2016
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International cost of capital is a financial term that is loosely defined and arrived at, but basically represents what the minimum expected rate of return can be for an investment in a foreign market that is sufficient to draw funds into that market. This is seen as an opportunity cost because it means that, when investors take risks in a particular foreign market, they are forgoing the opportunity of investing their capital assets elsewhere. Normally, the higher the risk, the higher the international cost of capital. This leads to the basic premise that emerging markets and developing nations have a higher international cost of capital both because they are more unstable markets and because the data available to analyze appropriate levels of risk for the investor is usually more unreliable or scarce than in first-world economies.

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Just as defining the concept of international cost of capital can be something of a fluid situation, arriving at actual figures for what it is market by market can also differ due to over a dozen different financial analysis approaches used to reach conclusions. While some of these methods produce closely similar results, others are ad hoc calculations that vary widely. One of the most common ways to look at the risk of investing in foreign interests and what type of returns these investments can offer is to approach the problem from a systemic point of view. This means that diversification among different industries within the country would not offer any added protection from risk for the investor.

An established systemic approach first conceived in the early 1960s is known as the Capital Asset Pricing Model (CAPM). While CAPM was initially based on US market data, it has since been expanded to a world scope as of 2011 and it directly compares risk against rates of return. Markets are evaluated based on both the inherent risk that they hold and the amount of time that an investment must be held there to generate an expected rate of return.

A formula for the CAPM model would be CAPM = Rf + Bs(Rm – Rf), where Rf equals the risk-free rate, Bs equals the beta of the security, and Rm equals the expected return on investment. The risk-free rate is defined as what a return rate would be on a comparable risk-free security and the beta is defined as the overall risk measure for the investment as compared to a market premium return rate (Rm). An example for determining the expected return with such a formula to see if it's worth investing in would be an Rf of 4%, a beta of 2, and a premium rate of 8% for 12% = 4% + 2 (8% - 4%). Since 12% is a fairly low return for an investment in a risky market over an extended period of time, this might warrant putting one's assets elsewhere.

The CAPM model was discredited in the early 1990s, though it had been validated in over 18 foreign markets, because it did not match data for the Japanese investment sector. One of the variables in the equation that can produce erroneous results is the tying of the beta factor to perceived risk country by country. Emerging markets also showed wide variance between beta values and expected returns.

Flaws in CAPM led to many other methods for calculating international cost of capital. The World Multifactor Capital Asset Pricing Model emerged in the mid-1970s to factor in more dynamic ways of calculating changing risk premiums. The Bekaert and Harvey Mixture Model compensated for how thoroughly integrated local markets are into the international trading community, and the Sovereign Spread Model or Goldman Model incorporated a nation's bond yield values, as tied to the US market as a reference point, to more accurately calculate beta. The Sovereign Spread Model itself was seen to have significant flaws, and subsequent models were created to refine it, including the Implied Sovereign Spread Model, the Sovereign Spread Volatility Ratio Model, and the Damodaran Model.

Several other formulas and risk calculation models followed in ensuing years to calculate the international cost of capital. Economists use a variety of these models to arrive at values which are then averaged out. Despite an attempt to arrive at a consensus for predictable risk, however, several key factors throw off any international cost of capital conclusion. Among these is the fact that, in emerging markets, significant crisis in political or economic systems can often arise that greatly throw off predictions of risk, so the models are only considered valid for time spans of less than ten years when dealing with inherently unstable markets.

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