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Philippine Long Distance 0.92 8.74 18.37 5.23 12.68

Portugal Telecom 1.73 7.60 14.68 4.72 10.75

SK Telecom -1.01 10.00 33.01 4.62 16.39

TDC A/S 2.09 8.30 17.27 5.09 11.87

Telecom Argentina 2.37 12.62 27.30 7.38 18.68

Telecom Italia 2.01 6.42 14.23 3.99 9.20

Telefonica de Argentina 1.83 11.61 25.74 6.79 17.15

Telefonica del Peru 1.80 10.34 22.43 6.01 15.29

Telefonica SA 1.40 7.66 14.76 4.72 10.95

Telefonos de Mexico 1.50 6.88 13.63 4.21 9.88

Telekomunidasi Indonesia 1.38 10.71 27.16 5.83 16.77

Vodafone 0.49 7.23 16.25 4.40 10.41

Nextel 1.91 13.10 30.72 7.36 19.85

AT&T 1.42 7.82 15.75 4.78 11.21

Verizon 1.37 6.10 14.42 3.46 9.12

Notes: 5,000 simulations were performed for each company in the table. A triangular
distribution function with parameters 0.5, 1.19 and 2.25 was assumed for the risk free
rate. A normal distribution with mean 4 and standard deviation 1 was assumed for the
market risk premium. A normal distribution was assumed for each company™s risk
measure using company sample values for the mean and standard deviation.

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Risk and Investment in the Global Telecommunications Industry 57

Future Trends
Countries around the world are experiencing an increase in the convergence of global-
ization, financial markets and technology. Economic growth is tied closely with this
convergence and it is expected that this convergence will continue into the foreseeable
future. This convergence comes at a time when equity market volatility is high, thereby
emphasizing the need for the practice of good risk management techniques. Policy makers
in both developed and developing counties realize that economic growth is driven by
enhancements in productivity and productivity growth, in turn, is driven by increases
in technology. Affordable and reliable telecommunications are essential to the wealth
and creation process of any country (Landes, 1998). Privatization and favourable
regulatory changes in the global telecommunications industry can lead to greater
productivity and profits. Privatization also requires well functioning capital markets, as
new sources of debt and equity are required for those companies in industries being
The telecommunications industry is characterized by high fixed costs, increased compe-
tition due to privatization and huge opportunities for growth in developing countries.
As in all industries, companies can compete on price or product differentiation (including
quality). In some regions of the world, it is just too costly to install wire-line services.
In these instances, wireless services present a viable alternative. The build-out of new
telecommunications services requires financial capital. Globalization (broadly character-
ized as in increase in the trade of goods and services and an increase in foreign
investment) can help by increasingly matching owners of scarce financial capital with
those who need it. But foreign investment comes at a price. Namely, that investors
compare various investment projects in a particular risk class and choose the one with
the highest return. Telecommunications companies in developing countries can attract
foreign capital if they offer a competitive risk-adjusted expected return.
Equity investors, in particular, because they rank after debt holders for claims on
company assets, must have good measures of risk-adjusted, expected returns. In the
future, investors and policy makers alike should make the cost-of-equity calculations
made in this chapter to help gain a better understanding of the tradeoffs between risk and
return in the global telecommunications industry.

Access to affordable technology to improve the flow of information is essential to the
development of an economy. Closing the Digital Divide could bring many benefits to
developing countries. In many ways, developing countries have the most to gain from
improvements in telecommunications and information technology. Bringing the benefits
of IT to developing countries is possible, but the governments of these countries need
to be aware that the process is going to cost money and require institutional changes.

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permission of Idea Group Inc. is prohibited.
58 Henriques & Sadorsky

The basic economic production function mixes capital with labour, energy and materials
to produce output. Capital consists of physical capital (buildings, plants, machinery),
human capital (knowledge) and social capital (customs and institutions) (Landes, 1998;
Helliwell, 2002). Smooth, well functioning feedback between these three types of capital
is essential to promoting a fertile economic environment for entrepreneurs and business
and provides the most direct path to productivity improvements and high living
International investors will frequently calculate the cost of equity for their existing
investments and their proposed investments. Development planners must be able to
make their own cost-of-equity calculations so that they can see first hand how their
investment projects compare with other investment projects around the globe.
Consequently, it is necessary to have good measures of equity risk for managers,
planners, policy makers and investors. The cost of equity is important in valuing new
investment opportunities and in evaluating the ongoing performance of established
business projects. This is especially true in the new economy IT industry where an
understanding of equity risk aids in the examination of the relationship between the IT
sector and economic development.
Estimates of the cost of equity for a particular company vary widely and depend upon
the methodology used. For a particular company, cost-of-equity values based on
systematic risk tend to be lower than cost-of-equity values calculated from downside risk
measures. For some companies, downside cost-of-equity values are twice as large as
cost-of-equity measures based on systematic risk. This is true, even though all of the
cost-of-equity values use the same risk-free rate and same risk premium.
The cost of equity is an essential ingredient for investors seeking estimates of risk-
adjusted returns from an equity investment. The cost of equity is also crucial to project
evaluation and project evaluation is crucial to the success of any firm. Small changes in
the cost of equity can have large impacts on the net present-value calculation of a project
valuation. Large cost-of-equity values lower present-value calculations while small cost-
of-equity values raise present-value calculations. The results in this chapter suggest
that, while systematic risk is a well known measure of equity risk, a prudent investor in
global telecommunications companies might also wish to calculate risk measures based
on total risk, value at risk, downside risk, and regret. Our approach is not to rely on just
one cost-of-equity value but to calculate several different cost-of-equity values and then
use simulation techniques to build up a probability distribution for each company™s cost
of equity. In this way, a clearer picture of where a company™s true cost of equity lies is
developed. Simulation results are insightful because different distributions can have the
same mean values but have very different shapes. For project evaluation and investing,
for example, distributions that are skewed to the right are much preferred to distributions
that are skewed to the left.
One of the insights that emerges from our study is the fact that the average cost of equity
for telecommunications companies in developing countries is not always greater than the
average cost of equity for telecommunications companies in developed countries. This
is borne out by the high cost-of-equity calculations for Cable & Wireless, France
Telecom and Nextel. In general, it is difficult to find evidence of regional differences in
the average cost of equity of telecommunications companies. This is useful to a

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permission of Idea Group Inc. is prohibited.
Risk and Investment in the Global Telecommunications Industry 59

development planner who can then use a portfolio approach in which high-risk invest-
ments are combined with low-risk investments to promote an investment in a developing
country™s telecommunications industry. Provided a developing or emerging economy
can offer attractive risk and return characteristics to investors of financial capital, funds
from portfolio investment should not be overlooked as a source of financial investment

We thank an anonymous reviewer and the editor for helpful comments.

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60 Henriques & Sadorsky

Helliwell, F.F. (2002). Globalization and Well Being. Vancouver: University of British
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permission of Idea Group Inc. is prohibited.
Risk and Investment in the Global Telecommunications Industry 61

The risk measures (RM) and associated cost of equity (CE) are calculated as follows:

RMSR = βi/ βM = βi

CESR,i = Rf + (RPM) βi (A1)

RMTR = σi/ σM

CETR,i = R f + (RPw) σi/ σM (A2)

RMDRj = Σji/ ΣjM , j = µ, 0, f

CEDRj,i = Rf + (RPM) Σji/ ΣjM (A3)


CEVAR,i = R f + (RP M) VARi/VARM (A4)

RMDBj= βji/ βjM = βji j = f, 0

CEDB,ji = Rf + (RPM) βji (A5)

RMREG J= REGji/ REGjM j = f, 0

CEREG,ji = Rf + (RPM) REGij/REGMj (A6)

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permission of Idea Group Inc. is prohibited.
62 Pfahler & Grebe

Chapter IV

Reduction of
Transaction Costs
by Using
Electronic Commerce
in Financial Services:
An Institutional and
Empirical Approach
Thomas Pfahler
University of Bayreuth, Germany

Kai M. Grebe
University of Bayreuth, Germany

This chapter introduces the Transaction Cost Approach as a means of analyzing
specific transactions in financial services by using the theoretical framework of New
Institutional Economics. It argues that transaction costs can be assessed and used to
compare different business processes. Furthermore, these costs allow a detailed
explanation why certain underlying technologies which form the basis for transactions
become widely accepted whereas others do not prevail. The authors emphasize the

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permission of Idea Group Inc. is prohibited.
Reduction of Transaction Costs by Using E-Commerce in Financial Services 63

relevance of this approach and its application to the field of electronic commerce both
on a theoretical and practical level to document and to interpret current trends in this
sector on the one hand, and to predict future developments on the other hand.

The authors analyse the impact of the increasing utilization of information and commu-
nication technology (ICT) and electronic commerce on the coordination of specific
transactions in financial services. In particular, two business processes commonly
occurring in the contractual relationship between a financial institution and its customers
will be considered: bank transfers and stock purchases. The chapter focuses explicitly
on the relationship between a bank and its customers which, in contrast to internal and
inter-bank processes that have already been subject of intensive research, has been
neglected so far.
The basic principles of New Institutional Economics and the instruments developed in
the context of the Transaction Cost Approach serve as theoretical background for the
study and further discussion. The chapter develops and implements a proposal how to
exemplify and to compare these processes under the varying influence of certain
technologies. Therefore, a cost model is developed that will be used in the following to
assess two basic transactions in this specific area. The intention is to reveal the basic
phenomenon and to document the reasons for the current utilization of ICT in this sector
by emphasizing relative reductions of transaction costs by means of electronic com-
merce. The basic statements and conclusions are underlined and illustrated for Germany
in an empirical section. At the end of the chapter, future perspectives and impacts on the
chosen topic will be given and derived.

Electronic Commerce
The need to explain the most important terms and definitions in this context arises directly
from the topic chosen. Choi/Stahl/Winston (1997) define electronic commerce as “a new
market offering a new type of commodity, such as digital products through digital
processes.” This specification already indicates the potential scope and the enormous
consequences which result from the use of electronic commerce.
More fundamentally, electronic commerce can be seen as any economic activity on the
basis of electronic connections (Picot/Reichwald/Wigand, 2001). Hence, it follows that
the underlying technology is crucial to promote the acceptance and the use of electronic
commerce. The use of digital lines and early devices to generate and to exchange
information between participants in the economic cycle was a first step. The introduction
of telephone and telefax services can be seen as the advent of a massive development
which turns out to be the “digital revolution.” Phone lines can be used to connect

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64 Pfahler & Grebe

computers to the Internet, and digital data highways have been implemented to overcome
limitations and to assure rapid processing. Mobile phones or Personal Digital Assistants
(PDA) enable users to interact and to participate in new as well as in established markets
from almost anywhere at any time.
Electronic commerce can generally take place between two businesses, between a
business and an administration, or between a business and a consumer. In the following,
only the relationship between a business and its customers will be investigated. The
object of the analysis is the financial sector.
Financial institutions hold special positions in the business cycle and differ in many ways
from other corporations or firms. Economically, they perform the functions of liquidity
equalization, of processing information and of conducting several transformations.
Special laws and directives are applied and the services offered are abstract and
immaterial (Büschgen, 1998). Moreover, these services need explanations and need to
integrate an external factor: the bank customer.
In view of these facts it seems evident that the financial sector is likely to be more affected
by the emergence of new technologies than other sectors might be. Consequently, banks
have internally been using information and communication technologies for a long time
to process a large number of highly standardized operations. In the last few years,
especially the core business of banks has been at the center of attention”and it has
changed in several ways. The interface between the institution and its customers has
become increasingly important. New ways of contacting and transacting have been
implemented for mutual benefit and changed their relationship. Customers are now much
more integrated in the transaction process and may easily arrange their affairs through
the use of electronic commerce without having to be on site. Banks will be able to
reengineer business processes, offer new products and reduce personnel costs.

New Institutional Economics
There are many possible approaches to investigate different aspects of information and

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