What is Country Risk Premium?
Country Risk Premium is defined as the additional returns expected by the investor in order to assume the risk of investing in foreign markets as compared to the domestic country.
Investing in foreign countries has become more common now than it was before. A United States investor might like to invest in the securities of Asian markets say China or India. This is as much alluring as risky it is. The geopolitical scenario is not the same in different regions of the world. There are risks associated with every economy and Country Risk Premium is a measure of this risk. Since the certainty on investment returns in foreign markets is generally less as compared to domestic markets, It becomes vital here.
In our hypothetical example here, China faces its own sets of macroeconomic risks. These risks make investors skeptical about their investments. For any given asset, market risk premium, as believed by many analysts, does not capture the excess risk posed by the economic factors of the country.
Factors to consider while estimating Country risk premium:
- Macroeconomic factors like inflation.
- Currency fluctuations.
- Fiscal deficit and related policies.
Country Risk Premium Calculation
Country risk premia can be based on the yields on sovereign bonds because these securities give a good picture of the macro within a country. To a couple, it with the equity and bond market indices is to strengthen the risk measurement. Both these markets hold substantial amounts of investor monies which make them a better indicator of country risk.
Country Risk Premium Formula
The formula for Country risk premium is:
Thus, more technically,
Examples
Let’s see some examples of country risk premium calculation to understand it better.
Example #1
If a country has an annualized return of 18% and 12.5% on equity and bond index respectively over a 5-year period, what is the country risk premium? The country’s treasury bond has yielded a 3.5% return whereas sovereign bond has a 7% yield on a similar period.
Solution:
Simple substitution in the formula above gives us the CRP.
- CRP = (7% – 3.5%) x (18%/12.5%)
- CRP = 3.5% x 1.44%
- CRP = 5.04%
Example #2
Calculate the CRP with similar yields as in the example above, other than the equity index yield which is 21%.
Solution:
Again, putting the values in the formula, we get
- CRP = (7% – 3.5%) x (21%/12.5%)
- CRP = 5.88%
Notice that as equity index yield goes up from 18% to 21%, the CRP increases from 5.04% to 5.88%. This can be attributed to the higher volatility in the equity market which has produced a higher return and hence raises the CRP with it.
Country Risk Premium Calculation & CAPM
Country risk premium finds most use in the CAPM (Capital Asset Pricing Model) theory. A CAPM model is a measure of return on equity considering the non-systematic risk or firm risk where,
- Re is the return on equity,
- Rf is the risk-free rate,
- Β is the Beta or market risk, and
- Rm is return expected from the market.
We have two approaches to estimate Rebased on the inclusion of CRP.
- One way to include country risk premium (CRP) is to add it to the risk-free and risky asset component. Hence,
- Another way to include CRP in the CAPM model is to make it a function of firm risk.
Approach 1 differs from 2 in that Country risk is unconditional addition to every firm’s risk-return profile.
Example #3
Calculate the return on equity from the following information:
Solution:
From both the approaches, we have the following results,
Approach 1
- Re = Rf + β x (Rm-Rf) + CRP
- Re = 4% + 1.2 x (8% – 4%) + 5.2%
- Re = 14%
Approach 2
- Re = Rf + β x (Rm-Rf + CRP)
- Re = 4% + 1.2 x (8% – 4% + 5.2%)
- Re = 15.04%
Investors’ Perspective
While the equity risk premium gives investors the incentive to invest in risky assets in domestic markets, It provides further impetus to accept uncertainties in foreign markets. Some of the plus points of CRP are –
- To a major extent, country risk premia clearly distinguish between the risk-return profiles of developed economies as against developing economies. Prof. Aswath Damodaran has summarized country risk premia & related components on a global basis. Below is an excerpt:
- According to some analysts, beta does not estimate the country risk for firms thus resulting in a low equity risk premium for the same risk ventures.
- Some scholars also argue that the risks due to a country’s macroeconomics are better captured by the cash flow positions of the firm. This raises the issue around the futility of country risk estimation as an additional level of security.
Conclusion
In simple words, Country Risk Premium is the difference between the market interest rates of a benchmark country in comparison to that of the subject country. Of course, the less attractive economies have to offer a higher risk premium for foreign investors to attract investments.
It is a dynamic statistic that needs to be continuously tracked and updated in analyses around financial markets and investments. It assumes many factors whilst ignoring many others. Country risk can be better estimated when every significant aspect is appropriately valued in terms of risk and return. Events such as the Russia-NATO conflict, tensions in the Gulf region, Brexit, etc. have will certainly have an impact on the geopolitical risk scenario.
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