The EdgarStat® CUFT Loan Agreements Database (CUFT DB) contains primary market corporate loan transactions that have been entered into by mainly US borrowers. One of the most challenging transfer pricing issues regarding financial transactions is making a comparability adjustment for differences in country risk between the tested non-US borrower’s country and the comparable US borrower's country in pricing the intercompany loan interest rate. This tutorial deals with how to make a comparability adjustment for the difference in country risk using the methodology for calculating a Country Risk Premium (CRP). The question being addressed in this tutorial is: If the difference in country risk has a material impact on either the lender’s funding costs and/or the credit risk related spread, then how does an analyst make a comparability adjustment?
As a reminder the loan interest rate (IRate%) is the sum of the lender’s funding costs (or cost of funds, COF%, which is represented by a proxy, a market reference rate) and the spread required to compensate the lender for taking on the credit risk related to the borrower and the loan (i.e., the lending margin, or LM%).
IRate% = COF% + LM%
Before we go further with this tutorial let’s review the somewhat related concept of currency differences. Differences in the currency in which the intercompany loan is denominated compared to the currency in which the potentially comparable loans are denominated will require an adjustment to estimate the range of arm’s length interest rates. (See our tutorial on Making Currency Adjustment). If the tested intercompany loan is denominated in the local currency (i.e., not in USD) then the selection of the appropriate reference rate for the local currency and interest period would account for (most) of the difference in country risk between the foreign domiciled borrower and the US borrower. However, this is an adjustment to the lender’s funding costs (COF%) not to the LM%.
NOTE: In a recent study undertaken by CUFTanalytics with regards to comparable uncontrolled loan transactions entered by US borrowers that have multi-currency credit facilities (mainly involving LIBOR based currencies) the LM component of the loan pricing is, in most all cases, the same. The conclusion might be that there is no country risk difference other than what is reflected in the lender’s funding costs component of the interest rate.
But if we adjust only for the lender’s funding costs, is that sufficient to adjust for country risk? Or is there a material impact on the lending margin (LM) component of the interest rate due to differences in country risk?
Wikipedia has a nice definition of country risk:
… refers to the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country. For example, financial factors such as currency controls, devaluation or regulatory changes, or stability factors such as mass riots, civil war and other potential events contribute to companies operational risks. This term is also sometimes referred to as political risk however, country risk is a more general term that generally refers only to risks affecting all companies operating within or involved with a particular country.
One consideration for making a country risk adjustment is applying the concept of a sovereign credit rating cap on the tested borrower’s implied credit rating. This would be a cap on the estimated implied credit rating for the tested non-US borrower/ intercompany loan based on the sovereign credit rating of the country in which the tested borrower is incorporated and operating. This cap may change the search criteria (by capping the implied credit rating) and thus the range of LM results. In this approach, country risk is taken into consideration in the estimation of the implied credit rating. However, this still may not be a sufficient comparability analysis and adjustment.
The difference in country risk may have a material impact on the LM%; albeit in an indirect way. Specifically, the LM% is the sum of expected loss, EL% (i.e., EL% is, in turn, the product of the borrower’s probability of default, PD%, and loss given default, LGD%), an allocation of the lender’s operating costs (i.e., non-interest expense, or NIE%) and a return on the amount of economic capital (i.e., RoEC%) that the lender has available to cover unexpected loss (RoEC% is the lender’s profit element).
LM% = EL% + NIE% + RoEC%
Let’s consider the LM% components with regards to country risk.
The EL%, which can be mapped to credit rating categories, is the product of PD% and LGD%. These components can be different for the same borrower with the same loan if it were to operate in different countries.
NOTE: There are some commercial solutions, e.g., Moody’s Analytics’s LossCalc, in which, by changing the country of the borrower, one can see the impact on PD% and LGD% (and therefore EL% and the mapped implied credit rating).
Also, there may be data showing the differences in PD% for various industries by country. The analyst needs to consider: Is that change significant enough to require an adjustment, or at least consideration of an adjustment, to the LM results from the CUFT Database search?
While there could be some difference in the NIE% component of the LM% that a lender would need for a foreign based borrower compared to a US-based borrower, it would be a difficult task to quantify this difference, if it existed, in a reliable manner (i.e., with no available market data). Our assumption would be that there is no material difference (i.e., the lender would have the same allocation percentage for its operating costs and thus no adjustment for differences in NIE% due to differences in the borrower’s country would be required.
The other potential impact of a difference in country risk is to the return on economic capital (RoEC%) component of the LM%. If we assume that the components used to calculate economic capital (EC), (i.e., PD, LGD, VarPD, and VarLGD) do not change in a material way due to differences in the borrower’s country then a change in the LM% could only occur if the return on EC (or equity-at-risk) is different for the lender for a loan it makes to a non US-based borrower compared to a comparable loan made to a US-based borrower. By examining returns that investors require in the equity and debt markets this difference can be observed.
NOTE: The equity risk premium (ERP) is the excess return above the risk-free return for the additional risk (default and reinvestment) an investor takes compared to a risk-free asset. The CRP is a component of ERP. Since ERP is already considered in the comparable LM for the US-based borrowers we only need to calculate the CRP.
As an example, lets consider a US lender making a US$100 million loan to a corporate borrower in India. Also assume that the calculation of the amount of economic capital has been calculated at US$8 million.
As the comparable loan data (in the CUFT Database) will (most likely) be loan transactions entered into by US-based borrowers, we need to determine a CRP for lending to the Indian company to calculate its additional return on economic capital (i.e., CRP% x EC).
Based on academic research performed by Prof. Aswath Damodaran (NYU’s Stern School of Business) the formula for calculating the CRP, given India as the example, is:
India's CRP% = Spread on India's Sovereign Bond Index% X (Annualized StDev of India Equities/ Annualized StDev of India Government Bonds)
Damodaran uses Moody’s country (sovereign) ratings to estimate India’s country risk or its sovereign bond default risk. As of January 2021, India’s sovereign credit rating is Baa3. The default rate (or probability of default, PD) for a Baa3 rating (India’s sovereign bond rating) is 1.95% (while the USA’s sovereign bond rating is Aaa, which has a 0% default rate).
As this is a bond related default rate Damodaran then uses the volatility relationship between equities and bonds to convert it to a default rate for equities. In his January 2021 data the conversion ratio (annualized standard deviation of Indian equities to annualized standard deviation of Indian Government Bonds) is 1.09 (rounded). Thus, the CRP for India, as of January 2021, is estimated to be 2.13%.
India's CPR% = 1.95% x 1.09 = 2.13%
India’s CRP would be used to adjust the lender’s return on economic capital as an adjustment to the LM. To continue the example, we assume that the level of economic capital that the lender requires to be a buffer against unexpected loss for the US$100 million loan is US$8 million. The additional return the lender would require as compensation for India’s country risk is:
2.13% x US$8 million = US$170,400
This is a +0.17% (or +17bps) adjustment to the LM result based on data from credit agreements entered into by US borrowers in the CUFT Database (i.e., the calculating is US$170,400/US$100 million = 0.17%).
NOTE: If the loan, in the preceding example, is denominated in Rupees, then an adjustment is also made for the differences in the currency of the loan (i.e., the COF% adjustment). A proxy for the COF% may be the risk-free government bond yield.
Aswath Damodaran, "Country Default Spreads and Risk Premiums."
"India 10 Years Bond - Historical Data," www.worldgovernmentbonds.com.