There are two key questions that we face when we are asked to evaluate emerging markets in Asia, Latin America and Eastern Europe. The first relates to whether there should be an additional risk premium when valuing equities in these markets, because of the country risk.

As we will see, the answer will depend upon whether we view markets to be open or segmented and whether we believe in a one-factor or a multi-factor model. The second question relates to estimating an equity risk premium for emerging markets. Depending upon our answer to the first question, we will consider several solutions.

Should there be a country risk premium?

Is there more risk in investing in Malaysian or Brazilian equities than there is in investing in equities in the United States? The answer, to most, seems to be obviously affirmative. That, however, does not answer the question of whether there should be an additional risk premium charged when investing in those markets. Note that the only risk that is relevant for purposes of estimating a cost of equity is market risk or risk that cannot be diversified away.

The key question then becomes whether the risk in an emerging market is diversifiable or non-diversifiable risk. If, in fact, the additional risk of investing in Malaysia or Brazil can be diversified away, then there should be no additional risk premium charged. If it cannot, then it makes sense to think about estimating a country risk premium. But diversified away by whom? Equity in a Brazilian or Malaysian firm can be held by hundreds or thousands of investors, some of whom may hold only domestic stocks in their portfolio, whereas others may have more global exposure.

For purposes of analyzing country risk, we look at the marginal investor – the investor most likely to be trading on the equity. If that marginal investor is globally diversified, there is at least the potential for global diversification. If the marginal investor does not have a global portfolio, the likelihood of diversifying away country risk declines substantially. Stulz (1999) made a similar point using different terminology.

He differentiated between segmented markets, where risk premiums can be different in each market, because investors cannot or will not invest outside their domestic markets, and open markets, where investors can invest across markets. In a segmented market, the marginal investor will be diversified only across investments in that market, whereas in an open market, the marginal investor has the opportunity (even if he or she does not take it) to invest across markets. Even if the marginal investor is globally diversified, there is a second test that has to be met for country risk to not matter. All or much of country risk should be country specific. In other words, there should be low correlation across markets.

Only then will the risk be diversifiable in a globally diversified portfolio. If, on the other hand, the returns across countries have significant positive correlation, country risk has a market risk component, is not diversifiable and can command a premium. Whether returns across countries are positively correlated is an empirical question. Studies from the 1970s and 1980s suggested that the correlation was low, and this was an impetus for global diversification.

Partly because of the success of that sales pitch and partly because economies around the world have become increasingly intertwined over the last decade, more recent studies indicate that the correlation across markets has risen. This is borne out by the speed with which troubles in one market, say Russia, can spread to a market with which it has little or no obvious relationship, say Brazil.

So where do we stand? We believe that while the barriers to trading across markets have dropped, investors still have a home bias in their portfolios and that markets remain partially segmented. While globally diversified investors are playing an increasing role in the pricing of equities around the world, the resulting increase in correlation across markets has resulted in a portion of country risk being nondiversifiable or market risk. In the next section, we will consider how best to measure this country risk and build it into expected returns.

 

Prof. Aswath Damodaran

Next: Estimating a Country Risk Premium

Summary: Index