Annual Forecast

Chapter 1.
Chapter 2.

Lessons from the global crisis: The valuation of financial assets
under highly liquid conditions, and the appearance of more
frequently occurring extreme risks than in previous decades, has
led to a particularly unusual market context, that makes more
relevant the derivatives market and hedging instruments.

After the financial crisis, the relationship between the interest rate
swap government debt markets underwent a structural change,
especially with respect to long-term contracts, which demonstrated
the excessive demand for "low risk" assets.

Given the more challenging economic and financial environment,
the volatility hedge tools VIX and VXX, as well as those for
interest rates (interest rate and/or exchange rate swaps) are
progressively more relevant within risk and portfolio management
by market agents.

The development of the local interest rate swap market will
continue to gain relevance. This places their understanding,
accurate valuation methods, and analysis on the frontier of
development not only for the local but also for other capital
markets in the region.

Brian Lesmes
Economist specialized in Central Banks
and Financial System
blesmes@bancolombia.com.co
(571) 353 6.600

Andrs Ortiz
International Manager of the Economic
Research
androrti@bancolombia.com.co
(+571) 353 6.600

Juan Pablo Espinosa
Head of Economics and Fixed-Income
juespino@bancolombia.com.co
(+571) 353 6.600

http://investigaciones.bancolombia.com
Bloomberg: BCLB and VBCL

January 30, 2013
7 of 2012

Figure 1. Evolution and volatility of the VIX

Source: Bancolombia, Bloomberg.

Figure 2. Comparison between the S&P 500 index and
the replication index with hedges against extreme
risks of losses.
After the global crisis between 2008 and 2009, the world
economic environment underwent a series of changes, in
which higher uncertainty with respect to the behavior of
financial assets, among other things, is notable. The
methodology of measuring risk, the valuation of assets in a
highly liquid environment underpinned by the main
developed countries central banks and the appearance of
more extreme risks occurring more frequently than in
previous decades, have led to a particularly unusual market
context that is unprecedented in recent economic history.
The VIX is an index that uses the options market to measure
expectations of future volatility in the US stock market
reference index (S&P 500, Standard & Poors) and it is widely
used as a risk aversion barometer. The higher the index, the
higher the risk aversion; inversely, a lower level shows a lower
perception of risk. In the midst of international financial
turbulence, when the VIX recorded its historic highs, another
index was introduced: VXV, which represents or indicates
volatility expectations for market volatility (VIX). (See Figure
1).
This financial innovation reflected the interest of asset
managers to hedge risks that occur infrequently but have a
high impact on their portfolios, which is known as tail risk
(see Figure 2). The tracking of these indices has become a
constant for monitoring situations in which financial tensions
due to the economic crisis may give rise to unanticipated
losses in portfolios, and are becoming more relevant in the
vocabulary of professionals and financial market experts. The
existence of these exposures also reveals the importance of
using novel financial instruments, as a tool for efficiently
managing those risks.

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Figure 3. Swap spread in the United States (Measured
in basis points - bp)


Hence the relevance of the derivatives market and hedging
instruments.
Apart from extreme volatility, another important aspect to
note throughout the last few years is the behavior of the
relationship between the interest rate swap market and the
government bond market. This relationship, called swap
spread, measures the difference in basis points between the
fixed interest rate leg of a derivative contract/hedge fixed to a
floating rate leg (tied to a reference indicator) and a US
Treasury bond with the same maturity (benchmark), which is
used to calculate a market credit risk premium.
Under normal conditions, this risk premium is positive, since
US Treasury bonds are considered to be risk-free and
derivative contracts are traded by counterparties that have
credit risk (see Addendum). However, concern has arisen in
international academic circles that after the financial crisis
this relationship or spread became negative, especially in
long-term contracts, which reveals excess demand for "low-
risk" assets, and more willingness to enter into swaps
compared to investing in treasuries. Some opinions consider
that this alteration of the spread is explained by: (i) the
contractual differences for each instrument, (ii) the higher
perception of risk due to the fiscal situation in the United
States that increases the sovereign credit risk, (iii) the failures
in the use of the LIBOR rate as a reference indicator, (iv) and
others. (See Figure 3).
It is, therefore, important to monitor the evolution and
relationship of derivative/hedge contracts with other assets.
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2Y 10Y 30Y

Figure 4. Participation of IBR, CPI, Fixed Rate and DTF
in the issue of corporate bonds in Colombia

Source: Bancolombia, BVC; IOSCO-EMC Annual Meeting, Santiago de Chile,
Nov. 2012.

Figure 5. Participation of the swap market in
Colombia, by each type of asset

Source: Bancolombia, ICAP, GFI, Tradition, Prebon; IOSCO-EMC Annual
Meeting, Santiago de Chile, Nov. 2012.

Additionally there has been particular interest in determining
the following: What is the correct structure for rates in the
swap market? And what are the determining factors for the
behavior of these types of instruments?
These questions are not only important for the financial
markets in developed countries. Emerging markets have been
able to cope with a turbulent world environment and,
therefore, they need to safeguard recent success from
potential risks. Accordingly, the relevance and relationship of
derivative interest rate markets with respect to local assets
must also be a matter of interest for the Colombian market.
Despite being a relatively new interest rate indicator, the
Banking Reference Indicator (BRI) - has gained ground in
terms of the share of the Colombian capital market since
2008. For example, the issue of local corporate bonds indexed
to this indicator gained importance over the past few years. In
2009, only 4% of corporate bond issues were indexed to the
BRI. In 2011 this figure rose to 42% (see Figure 4). Meanwhile,
in the interest swap market the BRI also gained relevance
between the end of 2011 and 2012, to the detriment of the
DTF and Cross-Currency Swaps or Exchange Rate Swaps (see
Figure 5).
Over the past few years there has been a significant decline in
the regional swap curves. Within financial markets there has
been a drop in the swap rates in Brazil, Colombia, Chile,
Mexico, and Peruvian markets. A particular characteristic is
the correlation between these rates and an expansive
monetary policy cycle.
This section of the report seeks to identify the explanatory
factors, causality and transmission channels of swap rates to
their most liquid benchmarks (2, 5 and 10 years).
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Figure 6. Impulse - Response in the 2-year tenor for
CCS Colombia (measured in basis points - bp)






Given market and economic variables, the intention was to
identify how the more liquid benchmark in the Cross Currency
Swap (CCS) curve respond, where there is more historic data,
to a positive shock of 1 standard deviation (1 S.D) in a 12-
month period on various market and macroeconomic
variables.
The macroeconomic variables that showed the highest impact
on the CCS in the analysis were: (i) the product gap (the
difference between the observed GDP and its potential level),
(ii) the inflation gap (the difference between observed
inflation and the inflation expected by market analysts), (iii)
the National Central Government's (NCG) deficit, and (iv) total
debt (internal and external) as a percentage of GDP.
Among the market variables, the most liquid nodes in
Colombias Cross Currency Swap curve for and Latam were
taken into account as well as the IRS: Interest Rate Swap for
the United States. Based on the preceding analysis, it appears
that increases of one standard deviation in the interest rate
for 2-year US Treasuries and in the 10-year node for the IRS
curve in dollars (swap of the LIBOR rate for the fixed rate in
dollars) are associated with increases in the most liquid nodes
in Colombia CCS Curve. One aspect to consider is that in
Colombia's case the CCS curve is sensitive to the international
risk-free rates, especially in a context of ample liquidity.
Although not included in the results, monetary policy does
not have the most impact, but it does generate "causality".
Due to the above, if the rate expectations change in the
medium-term, for example, if US interest rates increase due
to less risk aversion or to inflationary effects, the CCS in
Colombia would be expected to adjust upwardly. A possible
explanation of this behavior is that a large part of the investor
base in this market is made up of players in global markets
that would use this instrument as a hedging mechanism. (See
Figures 6, 7 and 8)
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Figure 9. Impulse -Response in the 2yr CCS Colombia
given changes in the CCS Latam (measured in bp)

Figure 10. Impulse -Response in the 5yr CCS Colombia
given changes in the CCS Latam (measured in bp)

Figure 11. Impulse -Response in the 10yr CCS
Colombia given changes in the CCS Latam (measured
in bp)


It was also found that the CCS curve in Colombia is very
sensitive to market risk indicators such as the EMBI+
Colombia: Emerging Markets Bond Index, which relates to the
country risk premium, and the VIX.
This suggests that given increases in these risk variables,
market agents discount a downward bias in local rates, which
are associated with reductions in the monetary policy rate in
response to increases in global uncertainty that have a direct
effect on economic activity. This association could owe to the
novelty of these rate instruments that have mainly been in
use over the past four years, which also coincides with the
period of the highest international volatility, as was explained
at the beginning of this report. (See Figures 6, 7 and 8)
Another approach is to identify how the main CCS curve in
Latam affects the evolution of the curve's nodes in Colombia.
A relevant aspect is that the Colombia curve maintains a
positive relationship with the most developed rate derivative
markets in the region, such as in Brazil, Mexico, and Chile.
This suggests that changes in the tone of monetary policy in
the region moving from a neutral position to a more
hawkish or dovish position are effectively reflected by the
CCS in Colombia.
By contrast, the CCS nodes in Peru maintain a negative
relationship with the Colombian curve nodes. This may be due
to the fact that the Peruvian economy is semi-dollarized, and
its monetary policy is strongly oriented to attempting to
minimize exchange mismatches, which does not necessarily
coincide with the monetary policy cycle in Colombia. (See
Figures 9, 10 and 11)
In conclusion, we emphasize that given the more challenging
economic and financial environment, these types of volatility
hedge tools VIX and VXX, as well as those for interest
rates (interest rate and/or exchange rate swaps) are
progressively more relevant within risk and portfolio
managers.

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The development of the local interest rate hedge markets will
continue to gain relevance in coming years. This places their
understanding, accurate valuation methods, and analysis on
the frontier of development for the local and regional capital
markets in the coming years.
To analyze the fixed income market, it is very useful to include
the listed prices for swap contracts. In theory, in which
arbitrage opportunities are completely exhausted and market
friction is irrelevant, the information regarding the temporary
structure of interest rates is uniform among all instruments,
whether spot or derivatives. However, given the real worlds
complexities, the signs offered by swaps acquire particular
validity in the following respects:
1. The interest rate swaps spreads are highly influenced by
liquidity conditions in the financial market. In times of
ample liquidity, as is currently the case in the main
developed economies, there are significant reductions in
the swap spreads. This is due to the ease of obtaining
funds, the high appetite for risk and the search for higher
yields that characterize these situations. The broadening of
swap spreads may therefore be an indication of change in
the availability of resources in an economy.
2. The swap rates are also a good thermometer of the
perceived credit risk of the agents. While the sovereign
debt market in a nation operates under the premise of
nearly zero country risk, the swap spreads reflect the
perception of the average risk of intermediaries in that
market. This allows for the clear identification of concerns
that would otherwise go unnoticed. An example is the
current fear for the fiscal health of the United States in the
long-term (see page 3).

Figure 12. TES and CCS rates in the 2 year tenor


3. Thanks to the swaps it is possible to detect high financial
stress situations perceived by market agents. This is due
to the fact that in a debt security the buyer is exposed to
the payment of the principal by the issuer, while in
standard interest rate swaps this does not occur. A strong
preference for being exposed to one swap rate that leads
to a compression of spreads in that market, in turn may
suggest the possible occurrence of a credit event in the
spot market.
4. Given its flexibility and volume, the swaps market
facilitates the acquisition of exposure to certain assets in
a convenient manner, which overcomes the restrictions
that may occasionally arise in the spot market, both in
terms of the supply of securities and transaction costs.
This means that swap rates may capture agent
preferences early, before they are revealed in debt
markets. For example, Figure 12 shows that the 2-year
CCS in pesos has anticipated on numerous occasions
movement in the short portion of the Colombian
government debt curve over the past few years.

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CCS

New Market Dynamics: The divergent performance of fixed income
and equity markets over the past few years, coupled with the
better performance of the former, suggests that stocks at the global
level present more attractive entry levels.

A Different Situation in Colombia? The development at the local
level has presented certain similarities with respect to their
international peers, although local factors have prevailed in recent
years, especially with respect to fixed income securities. In
Colombia the perception is also that the equity market is more
attractive compared with the fixed income market, although
theoretically to a lesser degree than at the international level.

How much is risk worth? The Equity Risk Premium (ERP) measures
the additional return an investor would demand for investing in
risky assets, compared to investing in a risk-free asset. The implicit
ERP for Colombia is 6.89%, higher than the historic ERP of 5.4%, but
it is more reliable given the limitations of the second method.

Expensive or cheap? The local equity market is close to its fair
value, taking into account future corporate earnings and current
market risk. It was also found that stocks in Colombia are neither
undervalued nor overvalued with respect to sovereign bonds.

Mauricio Amador
Strategist for Portfolios and
Consumer Sector
mpilonie@bancolombia.com.co
(571) 353 6.600
http://investigaciones.bancolombia.
com
Bloomberg: BCLB and VBCL

January 30, 2013
7 of 2012

Figure 1. 10-year US treasuries

Figure 2. 10-year sovereign bonds Germany,
Switzerland, Denmark and Finland

Figure 3. 2-year sovereign bonds Germany,
Switzerland, Denmark and Finland
During the global financial crisis in 2008, the various equity
markets suffered sharp losses simultaneously, while there
was a notable recovery in 2009. During this time the fixed
income and equity markets showed similar behavior in
response to the crisis. However, their evolution over the past
three years has been uneven, which has given rise to a
significant gap between bonds and stocks, suggesting that the
latter is more attractive.
The ultimate safe harbor asset is the US 10-year Treasury and
it has recorded strong increases since 2010, as demonstrated
by the more than 200 bp decline in its yield. The fiscal crisis in
Europe has had a negative impact on rates, since investors
have sought more secure assets. However, the behavior of
this asset has not been completely rational over the past few
years. Treasuries appreciated significantly in 2010 when there
were doubts as to the sustainability of the country's economic
recovery. The same reaction took place with respect to the
2011 debt ceiling problem and the subsequent loss of the
"AAA" rating granted by one of the major rating agencies.
Although under normal conditions these events would have
led various investors to liquidate their positions, the
Treasuries have had a positive reaction. A large part of this
behavior is due to the three monetary stimulus packages (QE)
implemented by the Fed since the end of 2008, and the
different monetary policy tools that have been applied to
drive economic growth. Current rates, which in previous
months reached their lowest levels in history, are therefore
artificially low.
A similar phenomenon is observed in Europe when analyzing
the performance of fixed income security markets in countries
considered to be safe harbors. In fact, the nominal rates for 2
year bonds in countries such as Germany, Switzerland,
Norway, and Finland over the past few months have entered
negative territory for the first time in their history.
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Denmark Finland

Figure 4. Sovereign debt spread in peripheral
countries compared with Germany

Figure 5. Evolution of the MSCI Global index

Figure 6. Performance of stock indexes in the United
States, Europe and Japan
The picture is different in peripheral countries such as Greece,
Italy, Spain, Portugal, or Ireland. Their sovereign bonds
declined sharply in value in 2011 given the growing fears of
default and the possible breakup of the economic block.
However, in 2012 their performance reversed and they
exhibited significant increases in value due to the reduction of
their deficits and the implementation of strict austerity
policies.
The situation in equity markets was similar since several of
the uncertainties that affected fixed income securities also
had an impact on their behavior. However, their performance
was different. 2010 was a year in which the market recovery
continued, but at a slower rate, and the MCSI Global index
recorded increases of nearly 10%. The concerns mentioned
previously made 2011 more challenging for investors, and the
market erased nearly all the gains achieved in the preceding
year. A more encouraging picture arose in 2012, despite the
political uncertainty in the United States. Accordingly, the
gains accumulated since 2010 are practically the same as
those recorded the previous year.
There were, however, disparate results in the various stock
markets. Over the past three years, the S&P500 index has
appreciated by 28%, while the European market rose only
10%. There were also large differences between their
members. While the stock market in Germany rose by 28%,
the markets in Spain and Italy fell by nearly 30% and Greece
lost almost 60%. In Latin America the stock market indexes in
Mexico and Peru advanced by 36% and 46% respectively over
the past three years, while Brazil accumulated losses totaling
11%.
The divergent performance of fixed income and equity
markets over the past few years, coupled with superior
performance of the former, suggests that stocks at the global
level present more attractive entry levels.
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Figure 7. Performance of stock indexes in China, Brazil
and Mexico

Figure 8. Evolution of the Coltes index
Source: Grupo Bancolombia, BVC.

Figure 9. TES yield rate performance July 2024

The behavior of local markets presented some similarities to
their international peers, given the high correlation that they
exhibit and the impact on Colombia of events such as the
fiscal crisis in Europe, or the slowdown of the global economy.
However, local factors are those that have predominated in
the past few years, especially in the fixed income market.
Although TES yields also fell dramatically to nearly historic
lows, it cannot be said that they are artificially low. It is true
that a more expansive monetary policy with lower REPO rates
contributed to this performance. However, the better
economic outlook and lower inflation also gave rise to a
decline in the cost of debt in Colombia. There is also
increasingly less country risk, as reflected in the investment
grade rating granted to Colombia in 2011 by the main rating
agencies.
The local stock market also put in a good performance over
the past few years. The Colombian stock market ended 2010
with the Colcap index up by 33.4%, which made it one of the
markets with the best gains in the world, and number three
regionally, mainly due to the steep reduction in the perceived
country risk. As was the case internationally, 2011 was a
challenging year, although in Colombia the historic record of
new issues in the equity market had a significant effect.
Finally, last year's solid economic and corporate fundamentals
drove the stock market up by 16%.
Accordingly, in Colombia the perception is also that the equity
market is more attractive compared with the fixed income
market, although theoretically to a lesser degree than at the
international level.

50
70
90
110
130
150
Jan -10 Jul-10 Jan -11 Jul-11 Jan -12 Jul-12 Jan -13
Shanghai Bovespa Mexbol
90
110
130
150
170
190
Jan-08 Aug-08 Mar-09 Oct-09 May-10 Dec -10 Jul-11 Feb-12 Sep-12
5%
6%
7%
8%
9%
10%
ene-10 dic-10 nov-11 nov-12 Jan-10 Dec-10 Nov-11 Nov-12

Figure 10. Evolution of the Colcap index

Figure 11. Forecast for the Colcap index 2013
Source: Bancolombia.

This situation is not expected to change much in the short-
term, given the expectations regarding the various assets.
While the long end of the local government debt curve
showed a significant decline, further declines in 2013, even if
at a more moderate pace, cannot be ruled out. This would
occur due to the possibility of a new rate cut by Central Bank,
a positive economic outlook for Colombia within a context of
low inflation pressures. Similar performance is expected for
sovereign bonds at the international level, since the economic
stimulus in developed countries would continue, coupled with
a possible economic recovery of the main economies around
the world.
However, the outlook for the fixed income securities market
in 2014 is less encouraging in Colombia, given the possible
start of a tightening cycle by Central Bank, and influenced by
the international environment. In turn, the main catalyst for
this will be the exit strategy that could start to be
implemented by the U.S. Fed to drain liquidity from the
market.
The performance of the local stock market in the next few
years will be largely determined by the positive
macroeconomic outlook for Colombia, which would be
reflected in the solid operating and financial results obtained
by listed companies. This is why moderate increases in value
are anticipated for 2013, also supported by the relative
decline currently presented by the stock market. Similar
behavior is expected globally in the main stock markets,
although there are new challenges that investors will have to
face. Even though a tax agreement was reached in the United
States, the discussions regarding spending cuts and the raising
of the debt ceiling will continue to apply pressure and cause
uncertainty during the first few months of the year. The
concerns regarding the fiscal health of Europe continue but
have decreased as a result of the advances that were made in
2012.

1300
1400
1500
1600
1700
1800
1900
2000
Jan -10 Jul-10 Jan -11 Jul -11 Jan -12 Jul -12 Jan -13
2,186 (19.3%)
1,664 ( -9.2%)
2,018 (10.1%)
1,500
1,600
1,700
1,800
1,900
2,000
2,100
2,200
Jan -11 Jun-11 Nov -11 Apr -12 Sep-12 Feb-13 Jul -13 Dec -13
Points

The economic outlook is more optimistic, since various
analysts expect a further acceleration in the economies of the
United States and China.
This would take place under a framework of an expansive
monetary policy, which may be more visible during the
second half of the year. Corporate earnings would also
recover in line with the economy, and would be factors that
would positively affect global equity markets this year.
The short-term outlooks for fixed income and equities
markets are therefore positive. This means that investors
have to decide which is the best choice for investing their
capital. Concerns such as the following arise: How much more
earnings can be expected from stocks given the current return
offered by sovereign debt with a lower basic risk? Is the
higher risk assumed in equities justified, given their
fundamental outlook? Comparatively speaking, which market
may be able to present a greater gain?

The Equity Risk Premium (ERP), or Risk premium of the Stock
Market, is a tool that will help to partially answer these
questions. It measures the additional yield that will be
demanded by an investor to invest in risky assets, compared
with investing in risk-free assets. When the ERP goes up, it
means that agents are asking for a higher price for risk.
There are several factors that may influence the ERP level.
One of the most important is investor risk aversion and during
periods of high uncertainty and higher risk aversion, the ERP
will tend to rise. Another important element is the economic
situation in the country and its respective stability. There are
also other factors such as market liquidity and corporate
governance.

Table 1. Historical ERP in Colombia
TES Equities
2008 12.5% -17.2%
2009 21.1% 66.4%
2010 8.8% 35.4%
2011 7.8% -12.1%
2012 15.4% 20.0%
Average 13.1% 18.5%
ERP 5.4%

There are two important methods for estimating the ERP. The
first consists of analyzing historical returns from stocks
compared with risk free investments.
The difference over a prolonged period of time, and in annual
terms, will result in the historical ERP. Although this is one of
the most used methods, there are important differences in
the calculation that could give rise to different results. The
period of time chosen, the risk-free asset used, and the
method applied to average the returns will make the ERP
different.
In addition, Damodaran
1
argues that it is especially difficult to
implement this method in markets that have a short and
volatile history. Clear examples are emerging markets, which
have also undergone significant changes in the short-term,
have limited liquidity and, in general, are made up of a few
companies with large proportions in the market.
Despite these difficulties, the historic ERP for Colombia was
estimated. The Coltes index was used, as calculated by the
Colombian Stock Exchange, which measures the general
progress of the domestic TES Class B government debt
securities segment in pesos, and the total returns (including
dividends) of the main stock market index (the Colcap). It
should be noted that there is very little history available since
the information only dates from 2008. However, using this
period of time the historic ERP was found to be 5.4%,
although there is high volatility over time.
There is a second method to calculate the ERP. It consists of
estimating it with a view to the future based on the current
market level and future flows for investors. One of the
advantages of this ERP is that it does not depend solely on
past information and therefore may be applied to relatively
new and volatile markets. One of the most used methods to
calculate the implicit ERP is the discounted dividends method.

1
Aswath Damodaran, Equity Risk Premiums (ERP): Determinants,
Estimation and Implications. 2012.

Figure 12. Earnings per share vs. Colcap index

Figure 13. Colcap Earnings per share forecast


Under this method the equity value is equal to the present
value of the future dividends received from the investment.
In turn, the discount rate depends on the return demanded
by investors to invest in risky instruments. Finding the latter
value and comparing it against the risk-free rate determines
the ERP.
However, since only dividends are used, other aspects of
value for the investor may be missed. There is a body of
thought based on the theories of Modigliani and Miller
2
,
which argues that the dividends paid by a company are
irrelevant to its value. Over the past few years the notion
that dividends not paid to investors are reinvested in the
business has become more accepted, thereby generating
greater wealth for the stockholder due to the eventual
growth of the company. Warren Buffet agrees with this
concept in his theory of Look through earnings
3
.
Taking all of the above together, it must be borne in mind that
not all companies distribute dividends to their investors. In
general, mature companies have sustained dividend policies,
although there are significant exceptions such as Berkshire
Hathaway, Google, Amazon or even Apple, which started to
pay out dividends recently. The newer companies prefer to
reinvest in their own businesses to achieve growth, thereby
providing a higher rate of return, an event that occurs
frequently in emerging markets.
To estimate Colombia's ERP this paper uses a model that
includes the earnings per share for companies listed on the
Colcap index. The main variables and assumptions used in the
exercise are as follows:
Earnings per share (EPS): projected on an individual basis or
taken from the valuation models for the companies under
coverage.

2
F. Modigilani and M. Miller, "The Cost of Capital, Corporation Finance and
the Theory of Investment," American Economic Review, 1958.
3
Warren Buffet, An Owners Manual, Berkshire Hathaway, 1996.
10
35
60
85
110
135
700
950
1200
1450
1700
1950
Jan-08 Sep -08 Apr-09 Dec -09 Jul-10 Feb-11 Oct-11 May-12 Dec -12
Colcap
EPS (right axis)
10
35
60
85
110
135
160
185
210
235
Jan-08 May -10 Aug-12 Nov-14 Feb-17 Jun-19 Sep-21 Dec - -23

For other companies, both the economic growth of
the country and the inflation level were also taken
into account.
Risk-Free Rate: The exponential moving average of
the rate of return on Colombian TES sovereign bonds
maturing in July 2014, less the country risk
determined by the Colombian CDS (credit default
swap).
Perpetuity growth rate (g): Using the various
valuation models for the individual companies.

The model described above results in an implicit ERP of 6.89%
for Colombia. This is the percentage that an investor would
want in order to invest in the equity market, instead of
investing in a risk-free asset. This result is comparatively
higher than the nearly 6% rate calculated by Damodaran for
the United States, which seems to be coherent with the risk
associated with the characteristics of the country.
Furthermore, the 6.9% is also higher than the historic ERP of
5.4%, but it is more reliable given the limitations of this
method in emerging markets, as indicated previously.
It is important to note that the ERP is not a static variable over
time and it may change based on the market environment.
To analyze its sensitivity, we have used four different
scenarios, as follows:
1. If the Colcap had not recorded such a significant spike
in the final quarter of the year (+9%) and had been at
1,680 points.
ERP: 7.56%
2. If the Colcap had reached 2,000 points.
ERP: 6.28%
3. If the yield on the TES had continued to fall to 5%.
ERP: 7.60%

Table 3. Fair value model results

Current level Fair value
Potential
upside
Colcap 1,825 1,888 3.4%

4. If the yield on the TES had returned to its
mathematical average over the past two years (7.3%).
ERP: 5.30%
Under these scenarios, it is clear that a fall in the stock market
index or in the yield on sovereign bonds would give rise to a
higher risk premium for investments, which means that they
would pay a lower price for risky assets. Conversely, a rapid
increase in the stock market index or in the TES rates would
result in a lower ERP.

Although the implicit ERP indicates the premium that would
be required for risky assets, it does not provide a judgment of
the value of the stock market. It is, nevertheless, an important
component for estimating whether stocks are overvalued or
undervalued.
Two different approximation methods will be used in this
report. A model similar to that used for the ERP will first be
applied, since it takes into account the future gains in the
market calculated at present value.
The assumptions regarding earnings per share and the risk-
free rate are the same as those used to calculate the ERP, the
result of which also serves as an input for this model. Long-
term inflation for the Colombian economy (3%) and the
potential GDP (4.5%) is also used.

The final result of the model shows that the fair value of the
Colcap index today would be 1,888 points. This suggests that
the market is currently trading below its fair value, although it
would have moderate upside potential (+3.4%). This means
that the local equity market is close to its fair value. Notably,
if this same exercise is applied to the end of 2013, without
any significant change in the main variables, the model shows
a higher potential upside (+14.3%).

Figure 14. Performance of future gains in the Colcap
These conclusions are consistent with the performance seen
over the past few years. It should also be noted that the
Colombian market has reflected better performance than its
international peers since 2010. Although the Colombian
economy presents solid fundamentals, as do the main listed
companies, the result suggests that a large portion of those
fundamentals are currently included in stock prices.
There is another widely used approximation method to value
the equity market. The Fed Model was created by the
economist Ed Yardeni and despite its name it is not approved
by the US Federal Reserve. Its main objective is to determine
whether or not stocks are undervalued or overvalued
compared with sovereign bonds.
The model calculation uses the sovereign bond yield and the
return on future gains in the stock market index, calculated by
definition as the inverse of the price-earnings ratio. This
model compared both indicators such that if they have the
same value they are at their fair value, given the fact that the
underlying instruments are considered to be substitutes. If
the bond dividend is higher, it would mean that stocks are
overvalued and vice-versa. The reason is that bonds would be
offering a higher yield with lower associated risk.
However, there are limitations that must be taken into
account when using this method. Stocks may remain
undervalued or overvalued for a prolonged period of time and
therefore it does not indicate when the best time to change
strategy would be. The bond market also responds to specific
factors, which could cause a bias in the valuation of the
stocks.
The model currently indicates that stocks in Colombia are
neither undervalued nor overvalued with respect to sovereign
bonds. The performance of future gains in the Colcap index is
currently 5.3%, very close to its 5.2% historic average since
2009.

3,5%
4,0%
4,5%
5,0%
5,5%
6,0%
6,5%
7,0%
Jun-09 Nov-09 Apr-10 Sep-10 Feb-11 Jul-11 Dec-11 May-12 Oct-12
Return on Future
Earnings
Average

Taking into account that the yield on the July 2024 TES is
currently 5.4%, the result again suggests that the equity
market is close to its fair value. If compared with the risk-
free rate used in the previous exercises (discounting the
Colombian CDS), there would be limited upside potential.
The outlook for the local markets would therefore continue to
be favorable. The solid economic and corporate fundamentals
will continue to be included in stock prices, offering
continuous increases in value. However, the various visible
signs indicate that there is limited room available, and
therefore over the coming months no solid upswing in either
bonds or stocks is expected. In this scenario diversification
among assets becomes more relevant, in order to obtain
better yields while mitigating volatility in portfolios.
There are several methods for calculating the ERP and the
market's fair value, which reflect different results depending
on the variables used and the windows of time applied.
However, these conclusions are signs of the behavior of the
assets over time but are not precise tools to determine the
exact moment at which to make investment rotations.

(571) 353 52 87| Bogot Colombia

Juan Pablo Espinosa
Head of Economics and Fixed-Income
juespino@bancolombia.com.co
Andrs Ortiz
International Manager of the Economic Research
androrti@bancolombia.com.co
Alexander Riveros
Economist specialized in Colombian Macroeconomics
egrivero@bancolombia.com.co
Brian Lesmes
Economist specialized in Central Banks and Financial System
blesmes@bancolombia.com.co
Lucas Toro
Strategist for Corporate Debt
luctoro@bancolombia.com.co
Luca Duarte
Strategist for International Sovereign Debt and Forex
luduarte@bancolombia.com.co
Sebastin Franco
Intern
sefranco@bancolombia.com.co
Lina Snchez
Intern
lizetsan@bancolombia.com.co
(571) 353 66 00 | Bogot Colombia

Juan Nicols Pardo
Head of Portfolio and Equity Analysis
jnpardo@bancolombia.com.co

Mauricio Amador
Strategist for Portfolios and Consumer Sector
mpilonie@bancolombia.com.co
Juan Diego Meja
Strategist for the Financial Sector
juamejia3@bancolombia.com.co
Diego Buitrago
Strategist for the Energy and Infrastructure Sector
diebuit@bancolombia.com.co
Laura Manrique
Intern
lamanriqu@bancolombia.com.co
Luisa Fernanda Arce
Intern
luarce@bancolombia.com.co

DISCLAIMER
This report was drawn up by Bancolombia S.A.s Economic Research and Strategy Department in conjunction with Fiduciaria Bancolombias Financial Analysis Valores
Bancolombias Portfolio and Equities Analysis Departments, both latter entities belonging to the Bancolombia Group . The data and information herein contained should not be
considered as any advisory service, recommendation or suggestion on the part of the Bancolombia Group with regard to any investment decision or any type of transaction or
business to be carried out and therefore any use of such information shall be the sole responsibility of the user. The figures, interest rates and other data herein contained are for
informative purposes only and do not constitute any type of offer or firm demand for any transaction that may be performed in connection with such.

Person (s) pertaining or related to the Group may perform or have performed transactions with regard to one or more investments mentioned in this report before the
material was published; or may provide or have provided services to issuers of any of the investment products herein described, in strict compliance with all applicable
legislation. The information herein contained in connection with companies belonging to the Bancolombia Group does not necessarily represent the position taken by
such and may well reflect analyst opinions. We recommend that our readers periodically check the websites of BANCOLOMBIA S.A.(www.bancolombia.com),
Fiduciaria Bancolombia (www.fiduciariabancolombia.com) y Valores Bancolombia (www.valoresbancolombia.com), as well as Bloomberg BCLB, in order to maintain
themselves up to date with the latest publications of the Economic Research and Strategy Department.

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