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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