Country Risk Premium

Beta by itself does not adequately capture a country’s risk for companies that are located in developing countries. To appropriately reflect these country risks, the cost of equity is usually adjusted by adding a country risk premium.

The country risk premium may be added to the basic equity risk premium, which, anyway, does not account for country risk, to get the total equity risk premium. The equity risk premium is then used in the Capital Asset Pricing Model (CAPM) to derive the cost of equity.

Estimating Country Risk Premium

One common approach to estimating a country risk premium is to compute the product of a developing country’s sovereign yield spread and the ratio of the volatility of the country’s equity market to that of its sovereign bond market denominated in the currency of a developed country.

In the form of an equation,

$$ \begin{matrix} \text{Country risk} \\ \text{premium} \end{matrix}=\begin{matrix} \text{Sovereign yield} \\ \text{spread} \end{matrix}\times \frac { \begin{matrix} \text{Annualized standard deviation} \\ \text{of equity index} \end{matrix} }{ \begin{matrix} \text{Annualized standard deviation of} \\ \text{sovereign bond market in terms} \\ \text{of the developed market currency} \end{matrix} } $$

Where:

Sovereign yield spread = Government bond yield denominated in a developed country currency − Treasury bond yield on a similar maturity bond in a developed country

Also, the measure used to capture volatility is the annualized standard deviation.

Example: Calculating a Company’s Cost of Equity Using Country Risk Premium

The equity risk premium for a company in a developing country is 5.5%, and its country risk premium is 3%. If the company’s beta is 1.6 and the risk-free rate of interest is 4.4%, use the Capital Asset Pricing Model to compute the company’s cost of equity.

Solution

Total equity risk premium = 5.5% + 3% = 8.5%

Using CAPM, cost of equity = 4.4% + 1.6 (8.5%) = 4.4% + 13.60% = 18.0%

Question

Country A’s 10-year government bond yield is 7.5% while the yield on a similar maturity US treasury bond is 3.5%. The annualized standard deviation of Country A’s equity index is 30%, and the annualized standard deviation of country A’s United States dollar denominated 10-year government bond is 19%. What is country A’s country risk premium?

1. 6.32%
2. 7.24% 
3. 11.45%

Solution

The correct answer is A.

Sovereign yield spread \(= 7.5\% – 3.5\% = 4\%\)

Therefore, the country risk premium is:

$$ 4\%\left( \frac { 30\% }{ 19\% } \right) =0.04\left( \frac { 0.30 }{ 0.19 } \right) =0.04\left( 1.57895 \right) =0.06316=6.32\% $$