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%

Practice Question 1

To calculate the country equity premium, the sovereign yield spread which captures the general risk of the country should be adjusted for the volatility of the sovereign ______.

A. stock market
B. bond market relative to the bond market of the developed country
C. stock market relative to its bond market
D. stock market relative to the stock market of the developed country

Correct Answer: C

Practice Question 2

To calculate the country equity premium, the following inputs are needed:

I. Sovereign yield spread
II. Annualized σ of equity index
III. Annualized σ of the sovereign bond market in terms of the local currency
IV. Annualized σ of the sovereign bond market in terms of the developed market currency
V. Annualized σ of the equity index in terms of the developed market currency

Correct Answer: I, II and IV

The logic is that the sovereign yield spread captures the general risk of the country, which is then adjusted for the volatility of the stock market relative to the bond market.

Practice Question 3

Given the following information:

• Yield on 10-year government bond in Argentina: 9.5%.
• Yield on 10-year U.S. Treasury bond: 5.5%
• Annualized σ of Argentina's national stock index: 40%
• Annualized σ of the U.S. bond index: 10%
• Equity risk premium for a project in the U.S.: 10%

The equity risk premium for a similar project in Argentina is ______.

A. 16%
B. 26%
C. Not enough information is given.

Correct Answer: C

To calculate the equity risk premium, we need to know the annualized σ of Argentina's bond index.

Practice Question 4

Which is least likely to be a component of a developing country's equity premium?

A. Sovereign yield spread
B. Annualized standard deviation of the developing country's equity index
C. Annualized standard deviation of the sovereign bond market in terms of the developing country's currency

Correct Answer: C

The annualized standard deviation of the sovereign bond market in terms of the developing country's currency is not part of the equity premium calculation.

Country equity premium = sovereign yield spread x (annualized standard deviation of equity index / annualized standard deviation of the sovereign bond market in terms of the developed market currency)