Introduction to Country Risk Premium
The excess return that an investor demands for bearing a higher degree of risk by investing in a foreign market is known as the country risk premium and it is required by the investor to compensate her because she gives up the opportunity of investing in the safer domestic security and bears the risks imposed by investing in the foreign country securities.
- Every country finds it easier to pay off the security that is denominated in its own currency as it may ask the central bank to print more money to pay off the security. This process is called deficit financing, however, to pay a debt denominated in foreign currency, it needs to have sufficient reserves of the currency or the ability to purchase it.
- Further, every country has its own geopolitical issues and such issues affect the investors who have invested in the securities of a feign country because if the country goes into a war or becomes domestically unstable, the reduced returns might burn a hole in investor’s pocket too.
- So to compensate for all such uncertainties investors require a country risk premium. It is even used to determine the bond yields of a country. Some analysts take the equivalent US treasury securities and add this premium to determine the bond yield of the country’s securities.
Formula to calculate Country Risk Premium
Below is the formula for calculating the Country Risk Premium (CRP)
- What the above formula implies is that if a country is offering a certain yield on the government bond of a certain maturity, we should compare the yield to that offered by an equivalent US Treasury bond and the difference in yield is attributed to the country risk premium.
- Using the above formula we get the spread on the Sovereign bond and input that in the below formula, we can even determine the country equity premium required by the investors to invest in the riskier equity market of the country.
Example of Country Risk Premium (With Excel Template)
Let’s take an example to understand the calculation in a better manner.
Suppose, we have the treasury yield of 10 year bond of 5% while a bond issued by the Country X’s government has of the same maturity has a return of 8%, Using this we can calculate the country risk premium as follows. The measure required return on the equity investment in this country, we can look at the annualized standard deviation of the equity index and the bond index. Suppose there are 20% & 10% respectively.
Spread on the Sovereign Bond Yield is calculated using the formula given below
Spread on the Sovereign Bond Yield = Sovereign Bond Yield – US Treasury Yield
- Spread on the Sovereign Bond Yield = 8% – 5%
- Spread on the Sovereign Bond Yield = 3%
Country Equity Premium is calculated using the formula given below
Country Equity Premium = (Spread on Sovereign Bond Yield * Annualized Standard Deviation on Equity Index) / Annualized Standard Deviation on Bond Index
- Country Equity Premium = (3% * 20%) / 10%
- Country Equity Premium = 6%
So if the US Equity market index is returning 15%, then country X’s equity market investment should return at least 15+6 = 21% for the investor to bear the required amount of risk.
Any return greater than this should also be analyzed to see if the spread and premium measures are properly estimated and then only should the investor invest in such markets.
Incorporating Country Risk Premium to CAPM
As CAPM is one of the most popular measures of calculating the required return on equity, some analysts prefer incorporating the CRP in the CAPM formula. There are 3 ways to do so but each has a certain thought process backing it up.
CAPM formula is as follows:
- re = Required Return on Equity
- rrf = Risk Free Return
- β = Riskiness of Stock Market
- rM = Market Return
Simple Addition to Formula
- re = rrf + β(rM – rrf) + CRP
- This approach assumes that the Country risk premium is the same for all stocks that trade in a certain country
Beta Weighted Addition
- re = rrf + β(rM – rrf + CRP)
- This approach assumes that the stocks with higher beta also have higher exposure to the country risk premium
Lambda Weighted Addition
- re = rrf + β(rM – rrf) + λCRP
- This approach assumes that those stocks which have greater operations in the country are more exposed to the CRP than those which only have the headquarters in the country and most of the operations are situated in foreign countries such as the stocks of the multinational companies. The extent of exposure to CRP is measured by the lambda and is higher for those with greater operations in the country and vice versa.
Advantages and Disadvantages of Country Risk Premium
Below are the advantages and disadvantages of the same:
- Accounts for risk of investing in lesser developed markets: The investor gets aware of which market is riskier than others and what would be investing in a certain market entail and whether the investor has the risk appetite for the same. Looking at the return number in isolation can be tempting and misleading which country risk premium provides the investor with a reason behind whether such an investment is within his reach or not.
- Accounts for Macroeconomic factors: Country risk premium takes into account the factors such as higher rate of inflation, existing government debt, the current level of the business cycle in the economy, currency exchange rates and policies of capital movement among several other factors. This gives a complete picture of risk and therefore the measure is arrived at after a comprehensive analysis. Therefore such a measure leaves lesser chances of overlooking some factor of risk.
- Non Cash flow Measure: Estimating the country risk involves a lot of adjustments that are opinion-driven and are ultimately on estimates. They may vary from the actual risk and may not be able to capture the risk completely, however, cash flows are unadulterated. Basing the risk calculation on cash flow would lead to little or no uncertainty.
- Less Popular Measure: This measure is not one of the most popular measures of the risk of a country. Many analysts prefer the Capital Asset Pricing Model (CAPM) to be adjusted to incorporate the factors that are introduced in country risk and thereby eliminating the need for using the country risk premium.
Country Risk Premium is the measure for analyzing the additional risk imposed by investing in a country having a lesser developed financial market and greater geopolitical or macroeconomic risk. It is calculated and published on a periodical basis by Professor Ashwath Damodaran from Stern Business School and is referred to by many financial analysts. However, this calculation is based on estimation and educated opinions and may not be complete in capturing all the risks involved in investing in lesser developed countries.
This is a guide to Country Risk Premium. Here we discuss the introduction to Country Risk Premium with its example, formula calculation and also provide a downloadable excel template. You can also go through our other related articles to learn more –