Once country risk premiums have been estimated, the final question that we have to address relates to the exposure of individual companies to country risk. Should all companies in a country with substantial country risk be equally exposed to country risk? While intuition suggests that they should not, we will begin by looking at standard approaches that assume that they are.

We will follow up by scaling country risk exposure to established risk parameters such as betas and complete the discussion with an argument that individual companies should be evaluated for exposure to country risk.

The Bludgeon Approach

The simplest assumption to make when dealing with country risk, and the one that is most often made, is that all companies in a market are equally exposed to country risk. The cost of equity for a firm in a market with country risk can then be written as:

Cost of equity = Riskfree Rate + Beta (Mature Market Premium) + Country Risk Premium Thus,

for Brazil, where we have estimated a country risk premium of 7.67% from the melded approach, each company in the market will have an additional country risk premium of 7.67% added to its expected returns. For instance, the costs of equity for Embraer, an aerospace company listed in Brazil, with a beta¹² of 1.07 and Embratel, a Brazilian telecommunications company, with a beta of 0.80, in US dollar terms would be:

Cost of Equity for Embraer = 4.05% + 1.07 (4.53%) + 7.67% = 16.57%

Cost of Equity for Embratel = 4.05% + 0.80 (4.53%) + 7.67% = 15.34%

Note that the riskfree rate that we use is the US treasury bond rate (4.05%), and that the 4.53% is the equity risk premium for a mature equity market (estimated from historical data in the US market). It is also worth noting that analysts estimating cost of equity for Brazilian companies, in US dollar terms, often use the Brazilian C-Bond rate, a dollar denominated Brazilian bond, as the riskfree rate.

This is dangerous, since it is often also accompanied with a higher risk premium, and ends up double counting risk. It also seems inconsistent to use a rate that clearly incorporates default risk as a riskfree rate. To convert this dollar cost of equity into a cost of equity in the local currency, all that we need to do is to scale the estimate by relative inflation. To illustrate, if the BR inflation rate is 7%¹³ and the U.S. inflation rate is 2%, the cost of equity for Embraer in BR terms can be written as:

Expected Cost of EquityBR = 1.1657 (1.07/1.02) – 1 = .2228 or 22.28%

This will ensure consistency across estimates and valuations in different currencies.

The Beta Approach

For those investors who are uncomfortable with the notion that all companies in a market are equally exposed to country risk, a fairly simple alternative is to assume that a company's exposure to country risk is proportional to its exposure to all other market risk, which is measured by the beta. Thus, the cost of equity for a firm in an emerging market can be written as follows:

Cost of equity= Riskfree Rate+ Beta (Mature Market Premium + Country Risk Premium)

In practical terms, scaling the country risk premium to the beta of a stock implies that stocks with betas above one will be more exposed to country risk than stocks with a beta below one. For Embraer, with a beta of 1.07, this would lead to a dollar cost of equity estimate of:

Cost of Equity for Embraer = 4.05% + 1.07 (4.53% + 7.67%) = 17.10%

For Embratel, with its lower beta of 0.80, the cost of equity is:

Cost of Equity for Embraer = 4.05% + 0.80 (4.53% + 7.67%) = 13.81%

The advantage of using betas is that they are freely available for most firms. The disadvantage is that while betas measure overall exposure to macro economic risk, they may not be good measures of country risk.

The Lambda Approach

The most general, and our preferred approach, is to allow for each company to have an exposure to country risk that is different from its exposure to all other market risk.

For lack of a better term, let us term the measure of a company’s exposure to country risk to be lambda (λ). Like a beta, a lambda will be scaled around one, with a lambda of one indicating a company with average exposure to country risk and a lambda above or below one indicating above or below average exposure to country risk. The cost of equity for a firm in an emerging market can then be written as:

Expected Return = Rf + Beta (Mature Market Equity Risk Premium) + λ (County Risk Premium)

Note that this approach essentially converts our expected return model to a two-factor model, with the second factor being country risk, with λ measuring exposure to country risk.

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12) We used a bottom-up beta for Embraer, based upon an unleverd beta of 0.95 (estimated using aerospace companies listed globally) and Embraer’s debt to equity ratio of 19.01%. For more on the rationale for bottom-up betas read the companion paper on estimating risk parameters.

13) The average inflation rate in Brazil between 1998 and 2003 was 7.13%.

 

Prof. Aswath Damodaran

Next: Determinants of a company's exposure to country risk

Summary: Index