Country Risk Premium

Country Risk Premium

The only risk that is relevant for the purpose of estimating a cost of equity is market risk or risk that cannot be diversified away. The key question then becomes whether the risk in an emerging market is diversifiable or nondiversifiable risk. If, in fact, the additional risk of investing in another country can be diversified away, then there should be no additional risk premium charged. If it cannot, then it makes sense to think about estimating a country risk premium.

Country Risk Premium

Even if the marginal investor is globally diversified, all or much of country risk should be country specific. In other words, there should be low correlation across markets. Only then will the risk be diversifiable in a globally diversified portfolio. If, on the other hand, the returns across countries have significant positive correlation, country risk has a market risk component and is not diversifiable and can command a premium.

Measuring Country Risk Premium

Default Risk Spreads
Country Rating Market spread measures the spread difference between dollar-denominated bonds issued by the country and the U.S. treasury bond rate.

Cost of equity = Riskfree rate + Beta *(U.S. Risk premium) + Default Spread Risk of double counting

Measuring Country Risk Premium

Relative Standard Deviation Relative Standard Deviation Country X = Standard Deviation Country X /Standard Deviation US Equity risk premiumCountry X = Risk PremumUS *Relative Standard Deviation
Country X

Measuring Country Risk Premium

Relative Standard Deviation
Assume market premium for US stocks = 5.51% annual standard deviation of U.S. stocks is 20%. annual standard deviation of Indonesian stocks is 35%,

Measuring Country Risk Premium

Default Spread + Relative Standard Deviation

Measuring Country Risk Premium

Default Spread + Relative Standard Deviation
Brazil was rated B2 by Moody's, default spread of 4.83%. The annualized standard deviation in the Brazilian equity index over the previous year was 30.64%, annualized standard deviation in the Brazilian dollar denominated bond was 15.28%.

Which Approach to use?

Begin with the premium that emerges from the melded approach and to adjust this premium down towards either the country bond default spread or the country premium estimated from equity standard deviations. The differences between standard deviations in equity and bond prices narrow over longer periods and the resulting relative volatility will generally be smaller Equity risk premium will converge to the country bond spread as we look at longer term expected returns.

Estimating Asset Exposure to Country Risk Premiums

Assume that all companies in a country are equally exposed to country risk.
Expected Cost of Equity = 5.00% + 0.72 (5.51%) + 9.69% = 18.66% This is dollar cost of equity If inflation rate in Brazil is 10% and in US 3%

Estimating Asset Exposure to Country Risk Premiums

Assume that a company's exposure to country risk is proportional to its exposure to all other market risk, which is measured by the beta.
Expected Cost of Equity = 5.00% + 0.72 (5.51% + 9.69%) = 15.94%

Estimating Asset Exposure to Country Risk Premiums

Allow for each company to have an exposure to country risk that is different from its exposure to all other market risk.
Expected Return = Rf + Beta (Mature Equity Risk Premium) + (County Risk Premium)

BOA Approach
Expected Return = (RfUS + Premium for Credit Quality) + Adjusted Beta (Market Risk Premium)

Premium for Credit Quality = Default Risk Spread Adj Beta = India US Mkt * (India Mkt Index /US Market Index) Issues: Collaterals (Security) for Borrowing in US. Some percentage to be Invested in US. Brady Bonds Netted for Security India US Mkt is very small. Thumb rule is to work with a
figure of 0.6