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
One simple approach is to use the sovereign yield spread, which represents the yield on a developing country's US$-denominated bond vs. a U.S. Treasury-bond of the same maturity, as a proxy for the country spread. The sovereign yield spread primarily reflects default risk. This approach may be too coarse to estimate equity risk premium.
Another approach is to adjust the sovereign yield spread by using the following formula:
The country equity premium is then added to the equity premium estimated for a similar project in a developed country.
- Yield on 10-year government US$-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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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.
good comment Kutta
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
Well with risk diversification, the cost of equity can be reduced, no?
What will be the treatment in the case that a frontier market does not have a USD denominated bond market?
Search on Google: country risk premium Damodaran