As companies expand operations into emerging markets and investors search for investment opportunities in Asia and Latin America, the assessment of country risk has become a central component of valuation. In this paper, we considered two key questions. The first is whether there should be an extra premium assessed for country risk, and if yes how to estimate it.
While it is true that globally diversified investors can eliminate some country risk by diversifying across equities in many countries, the increasing correlation across markets suggests that country risk cannot be entirely diversified away. To estimate the country risk premium, we consider three measures: the default spread on a government bond issued by that country, a premium obtained by scaling up the equity risk premium in the United States by the volatility of the country equity market relative to the US equity market and a melded premium where the default spread on the country bond is adjusted for the higher volatility of the equity market.
We also estimated an implied equity premium from stock prices and expected cashflows. The second question relates to how this country risk premium should be reflected in the costs of equities of individual companies in that country. While the standard approaches add the country risk premium as a constant to the cost of equity of every company in that market, we argue for a more nuanced approach where a company’s exposure to country risk is measured with a lambda.
This lambda can be estimated either by looking at how much of a company’s revenues or earnings come from the country – the greater the percentage, the greater the lambda – or by regressing a company’s stock returns against country bond returns – the greater the sensitivity the higher the lambda. If we accept this view of the world, the costs of equity for multinationals that have significant operations in emerging markets will have to be adjusted to reflect their exposure to risk in these markets.
Prof. Aswath Damodaran
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