Discount Rates in Emerging Capital Markets

Samuel Mongrut Montalván () and Didac Ramírez Sarrió
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Didac Ramírez Sarrió: Universitat de Barcelona

Finance from EconWPA

Abstract: The estimation of the discount rate for an investment project in conditions of risk relies upon two crucial assumptions: market completeness and well-diversified investors. Although, these two assumptions are tenable in developed capital markets, they are not suitable in emerging markets. In emerging markets there are not enough twin securities to obtain a unique stochastic discount factor and therefore one project’s market value, and investors usually face short selling and borrowing restrictions. Furthermore, these markets are plagued with non-diversified entrepreneurs that invest all their capital to undertake entrepreneurial adventures. In this research one derives expressions for the project discount rate using the fundamental pricing equation under incomplete capital markets in two extreme situations: when investors hold a well-diversified portfolio and when they are not diversified at all. Although, both situations may apply in developed and emerging capital markets, they apply especially to emerging markets. In fact, well-diversified investors, such as foreign mutual funds, increasingly invest in emerging markets, while the bulk of firms involves either small or medium enterprises owned by a single or a group of non-diversified entrepreneurs. One concludes that although the CAPM cannot hold under incomplete markets it is still a good approximation for well-diversified investors in emerging markets, while it is necessary to use a hurdle rate based on the project total risk for the case of non-diversified entrepreneurs.

Keywords: Project valuation; incomplete markets; asset pricing (search for similar items in EconPapers)
JEL-codes: H43 D52 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ent and nep-fin
Date: 2005-01-30
Note: Type of Document - pdf; pages: 22
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Persistent link: http://EconPapers.repec.org/RePEc:wpa:wuwpfi:0501013

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