1. Measuring Risk in GEMs How High and at What Price? Kent Hargis Goldman Sachs & Co. February 27, 2000

2. GS-RAVE (Risk Adjusted Valuation in Equlibrium) Changes in Asset Prices are Driven by: 1. Changes in Expected Cash Flows 2. Changes in Discount Rates a. Risk Free Rate b. Risk Factors or Price of Risk

3. Drivers of Discount Rates Global Indicators Spread + Volatility Domestic Macroeconomic Indicators Company Indicators Useful to assess changes over time Useful in cross section analysis at a point in time

4. Drivers of Discount Rates DR = f ( Domestic + International ) Dom and Foreign Balance Sheet Wealth Growth and Earnings Stability of Cash Flows Management/Default History Global Risk Aversion Global Monetary Policy Commodity Prices

5. Domestic Fundamentals Have Improved

6. And is Reflected in Tight Spreads Relative to History

7. GEMs Volatility is Below Levels of Previous Crisis

8. And Is Declining versus the Rest of the World Ratio of GEMs to World and Nasdaq Volatility (Six month rolling average)

9. But GEMs Equities Have Not Performed Well

10. Because of an Increase in Global Risk Aversion U.S. Corporate Bond Spreads over Treasuries

11. As Perceptions of Equity Market Risk Have Increased Implied Volatility on S&P and NDX

12. Especially for Tech and Telecoms

13. Our Formulation to Assess Country Specific Risk R= R u +[R s +(S b /S u )E u (1– A) ] U.S. Treasury Yield Sovereign Spread Volatility Ratio U.S. Equity Risk Premium Double Counting Adj.

14. 1. Risk Free Rate 2. Measures of Risk 3. Price of Risk Discount Rates Are Composed of Three Factors

15. So What About Discount Rates in Emerging Markets? First, what is the appropriate risk free rate? Local versus International Rates Use Some Form of Weighted Average of the Local and Risk Free Rates in Proportion to the Participation of Local and Foreign Investors

16. What is the Appropriate Risk Free Rate in Emerging Markets? Problems with Local Rates 1. “Risk Free” Rates Do Not Exist 2. Long-Term “Risk-Free” Rates Do Not Exist Conclusion: Use U.S. Treasuries Because: 1. They Are Risk-Free 2. The Appropriate Long-Term Rate for Foreign Investors

17. Risk and Risk Premia Should Be: 1. Time-varying 2. Capture equity risk in addition to credit risk 3. Distinguish between high and low expected returns 4. Forward looking 5. Implementable for most markets on a timely basis What Are the Appropriate Measures of Risk and Risk Premia?

18. Alternative Measures of Risk 1. International Capital Asset Pricing Model 2. Time Varying Market Integration 3. Country Credit Ratings 4. Damodaran Model 5. Constant Credit or Risk Premium Spread 6. Historical Returns

19. Advantages of Our Approach 1. Premium for sovereign risk is observable 2. Sovereign spreads vary daily along with stock market volatility 3. As correlation approaches one, credit risk premium approaches equity risk premium 4. Forward Looking

20. Sovereign Spread Model Variables

21. Model Estimates

22. Emerging Market Spreads: Fit For Available Data Actual vs Predicted Emerging Market Spreads for the Sample Period (1994-1999)

23. Does it Work? Back-Testing the Model: 1975-99

24. 25 Years of Discount Rates for GEMs Correlation with stock market: Asia 43% Latam 70% EMEA 54% Correlation with stock market: 56%

25. Discount Rates for Latin America

26. Discount Rates for Emerging Asia

27. Discount Rates for Emerging EMEA

28. Conclusions l By decomposing discount rates into fundamental domestic and global drivers, the model is useful for investment strategy in emerging markets. l Risks can be global or local, macro or micro, debt or equity. l Our methodology permits calculation of rates for any country, any time, with or without a local bond or stock market. l Our model highlights the importance of global risk aversion, monetary conditions and commodity prices. l We believe the price of equity market risk in emerging markets will decline in the next 12 months.