Corporate Finance I

Reading 33. Cost of Capital

Learning Outcome Statements

j. describe uses of country risk premiums in estimating the cost of equity;

CFA Curriculum, 2020, Volume 4

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Subject 5. Country Risk

β seems not be able to capture country risk for companies in developing countries. Analysts often need to add a country spread (country equity premium) to the market risk premium when using CAPM to estimate the cost of equity.

One simple approach is to use the sovereign yield spread, which represents the yield on a developing country's US$-denominated bond vs. a U.S. Treasury-bond of the same maturity, as a proxy for the country spread. The sovereign yield spread primarily reflects default risk. This approach may be too coarse to estimate equity risk premium.

Another approach is to adjust the sovereign yield spread by using the following formula:

Country equity premium = Sovereign yield spread x (Annualized σ of equity index / Annualized σ of the sovereign bond market in terms of the developed market currency)

The country equity premium is then added to the equity premium estimated for a similar project in a developed country.

Example

  • Yield on 10-year government US$-denominated bond in China: 8.5%
  • Yield on 10-year U.S. Treasury bond: 6.5%
  • Annualized σ of national stock index: 50%
  • Annualized σ of the national US$-denominated bond index: 20%
  • Equity risk premium for a project in the US: 10%

Estimate the equity risk premium for a similar project in China.

Sovereign yield spread: 8.5% - 6.5% = 2%
Country risk premium: 2% x (50%/20%) = 5%
Equity risk premium: 5% + 10% = 15%

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User Contributed Comments 6

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kutta2102

I think the only problem with the sovereign risk premium approach is that it fails to take into account the diversification obtained by making international investment. International markets don't have a correlation of 1 with US markets so the equity 'risk' premium doesn't have to be additive. That's the whole reason all financial advisers have been asking to diversify internationally.

jpducros

good comment Kutta

RamaG

Point taken.. But the note here is to measure cost of equity for International capital projects, and not overall risk diversification achieved by international portfolio

syazwan21

Well with risk diversification, the cost of equity can be reduced, no?

Edchiu

What will be the treatment in the case that a frontier market does not have a USD denominated bond market?

MathLoser

Search on Google: country risk premium Damodaran