Country Risk Premium

What is Country Risk Premium?

Country Risk Premium (CRP) is the additional returns expected by the investor to assume the risk of investing in foreign markets compared to the domestic country.

Investing in foreign countries has become more common now than it was before. For example, United States investors might like to invest in the securities of Asian markets, e.g., China or India. That is as much alluring as risky as it is. However, the geopolitical scenario is not the same in different world regions. There are risks associated with every economy, and a country’s risk premium measures this risk. Since the certainty of investment returns in foreign markets is generally less than in domestic markets, It becomes vital here.

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We have taken a hypothetical example. Here, China faces its own set of macroeconomic risks. These risks make investors skeptical about their investments. For any given asset, market risk premium, as many analysts believe, does not capture the excess threat posed by the economic factors Economic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more of the country.

Country Risk Premium Calculation

The rates on sovereign bonds can be used to calculate country risk premia because these assets provide a good picture of a country’s macroeconomic situation. Put another way, it combines the equity and bond market indices to improve risk measurement. Both of these markets have large sums of investor money, making them more accurate country risk indicators.

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Country Risk Premium Formula

The formula for Country risk premium is:

Thus, more technically,

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Examples

Let us see some examples of country riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place.read more premium 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 5 years, what is the country’s risk premium? The country’s treasury bond Treasury BondA Treasury Bond (or T-bond) is a government debt security with a fixed rate of return and relatively low risk, as issued by the US government. You can buy treasury bonds directly from the US Treasury or through a bank, broker, or mutual fund company.read more has yielded a 3.5% return. In contrast, the sovereign bond has a 7% yield in 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 the example above, other than the equity index yield of 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 the equity index yield increases from 18% to 21%, the CRP increases from 5.04% to 5.88%. That can be attributed to the higher volatilityVolatilityVolatility is the rate of fluctuations in the trading price of securities for a specific return. It is the shift of asset prices between a higher value and a lower value over a specific trading period. read more in the equity marketEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more, which has produced a higher return and raised the CRP with it.

Country Risk Premium Calculation & CAPM

Country risk premium finds most use in the CAPM (Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more) theory. A CAPM model is a measure of return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more considering the non-systematic risk or firm risk when,

• Re is the return on equity,
• Rf is the risk-free rate Risk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor. It is the government bonds of well-developed countries, either US treasury bonds or German government bonds. Although, it does not exist because every investment has a certain amount of risk.read more,
• Β is the BetaBetaBeta is a financial metric that determines how sensitive a stock's price is to changes in the market price (index). It's used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more or market risk, and
• Rm is return expected from the market Return Expected From The MarketThe Expected Return formula is determined by applying all the Investments portfolio weights with their respective returns and doing the total of results. Expected return = (p1 * r1) + (p2 * r2) + ………… + (pn * rn), where, pi = Probability of each return and ri = Rate of return with probability. read more.

We have two approaches to estimating 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:

• Risk-Free Rate (R_f): 4%
• Expected Market Return (R_m): 8%
• Firm Beta (β): 1.2
• Country Risk Premium: 5.2%

Solution:

From both 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 incentivizes investors to invest in risky assets in domestic markets, it provides further impetus to accept uncertainties in foreign markets. Some of the advantages of CRP are: –

• To a significant extent, country risk premia clearly distinguish between developed economies’ risk-return profiles against developing economies. Prof. Aswath Damodaran has summarized country risk premia and related components globally. Below is an excerpt:

• According to some analysts, beta does not estimate the country risk for firms, thus resulting in a low equity risk premiumEquity Risk PremiumEquity Risk Premium is the expectation of an investor other than the risk-free rate of return. This additional return is over and above the risk free return.read more for the same risk ventures.
• Some scholars also argue that the risks due to a country’s macroeconomicsMacroeconomicsMacroeconomics aims at studying aspects and phenomena important to the national economy and world economy at large like GDP, inflation, fiscal policies, monetary policies, unemployment rates.read more are better captured by the cash flow positions of the firm. That raises the issue of the futility of country risk estimation as an additional level of security.

Conclusion

A country risk premium is a difference between the market interest rates of a benchmark country and 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 marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more and investments. It assumes many factors while ignoring many others. Country risk can be better estimated when every significant aspect is appropriately valued in risk and return. Events such as the Russia-NATO conflict, tensions in the Gulf region, Brexit, etc., will certainly impact the geopolitical risk scenario.

Frequently Asked Questions (FAQs)

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