Country Risk PremiumCopy Anchor Link

Country Risk PremiumCopy Anchor Link

The country risk premium is the additional return demanded for bearing the sovereign and macro risk of a specific country, added to a base equity-risk-premium when valuing cross-border cash flows. It is the mechanism by which aswath-damodaran's valuation framework handles the risk that does not travel with a mature-market premium. See valuation-across-asset-classes.

Why country risk is not diversifiableCopy Anchor Link

The first question is whether a country premium is needed at all. Damodaran addresses the objection directly: "On the issue of country premiums, there are some who argue that country risk is diversifiable, and that there should be no country risk premium", but the evidence of cross-market correlation means "a significant portion of country risk seems to be systematic and non-diversifiable even in a global portfolio." The 1980s practice of simply applying the US premium globally is therefore rejected. Damodaran's full ERP treatment frames the debate as a question about diversification: "the only risk that is relevant for purposes of estimating a cost of equity is the market risk or risk that cannot be diversified away", so the entire country-premium question turns on whether emerging-market risk can be diversified.

Measuring country riskCopy Anchor Link

The simplest measure is a sovereign debt rating, which "measure default risk (rather than equity risk) but they are affected by many of the factors that drive equity risk" — currency stability, budget and trade balances, political stability. Ratings have costs, though: "ratings agencies often lag markets when it comes to responding to changes in the underlying default risk", and their focus on default risk can obscure other risks that affect equity.

Converting default spread into an equity premiumCopy Anchor Link

The default spread is only a first step, because "we would expect the country equity risk premium to be larger than the country default risk spread." The adjustment uses the relative volatility of the country's equity market versus its sovereign bond: the country equity risk premium equals the country default spread scaled by the ratio of equity to bond volatility. Damodaran's worked Brazil example (June 1998) multiplies a 2.00% default spread by 34.9% equity volatility over 10.9% bond volatility to reach a 6.29% country equity risk premium.

Company-level exposureCopy Anchor Link

The premium is a country-level number, but firms differ in exposure. Damodaran lays out three views: all companies equally exposed; exposure proportional to beta; or — his preferred — a separate lambda allowing "each company to have an exposure to country risk that is different from its exposure to all other market risk." A commodity exporter earning dollars on global markets, for instance, is less exposed than a manufacturer serving the local market. The opening examples in his country-risk session — an Israeli software firm or a Nigerian oil company earning 95% of revenue in the U.S. — are designed to force exactly this question: is the premium about where the company is headquartered, or where its cash flows actually arise?

A warning about double countingCopy Anchor Link

A recurring error is to use a dollar-denominated sovereign bond as the risk-free rate and then add a country premium on top, which double-counts risk. The risk-free rate should be the government bond of the currency the cash flows are in, with the country premium layered on separately. The same care applies to the cost-of-capital: the country premium is an input to the discount rate, not a fudge factor applied after the fact. The relationship to dcf-valuation runs through every emerging-market terminal-value and explicit-forecast year.

SourcesCopy Anchor Link

• damodaran/markdown/riskprem.md
• damodaran/markdown/ERPfull.md
• damodaran/markdown/costofcapital.md
• damodaran/markdown/CountryRisk.md