Generally, the political risk related to foreign investment is added to the required rate of return.

What Is Country Risk Premium (CRP)?

Country Risk Premium (CRP) is the additional return or premium demanded by investors to compensate them for the higher risk associated with investing in a foreign country, compared with investing in the domestic market. Overseas investment opportunities are accompanied by higher risk because of the plethora of geopolitical and macroeconomic risk factors that need to be considered. These increased risks make investors wary of investing in foreign countries and as a result, they demand a risk premium for investing in them. The country risk premium is generally higher for developing markets than for developed nations.

Understanding Country Risk Premium (CRP)

Country risk encompasses numerous factors, including:

• Political instability;
• Economic risks such as recessionary conditions, higher inflation etc.;
• Sovereign debt burden and default probability;
• Currency fluctuations;
• Adverse government regulations (such as expropriation or currency controls).

Country risk is a key factor to be considered when investing in foreign markets. Most national export development agencies have in-depth dossiers on the risks associated with doing business in various countries around the world.

Country Risk Premium can have a significant impact on valuation and corporate finance calculations. The calculation of CRP involves estimating the risk premium for a mature market such as the United States, and adding a default spread to it.

Key Takeaways

• Country Risk Premium, the additional premium required to compensate investors for the higher risk of investing overseas, is a key factor to be considered when investing in foreign markets.
• CRP is generally higher for developing markets than for developed nations.

Estimating Country Risk Premium

There are two commonly used methods of estimating CRP:

• Sovereign Debt Method: CRP for a particular country can be estimated by comparing the spread on sovereign debt yields between the country and a mature market like the U.S.
• Equity Risk Method: CRP is measured on the basis of the relative volatility of equity market returns between a specific country and a developed nation.

However, there are drawbacks to both methods. If a country is perceived to have an increased risk of defaulting on its sovereign debt, yields on its sovereign debt would soar, as was the case for a number of European countries in the second decade of the current millennium. In such cases, the spread on sovereign debt yields may not necessarily be a useful indicator of the risks faced by investors in such countries. As for the equity risk method, it may significantly understate CRP if a country's market volatility is abnormally low because of market illiquidity and fewer public companies, which may be characteristic of some frontier markets.

Calculating Country Risk Premium

A third method of calculating a CRP number that can be used by equity investors overcomes the drawbacks of the above two approaches. For a given Country A, country risk premium can be calculated as:

Country Risk Premium (for Country A) = Spread on Country A's sovereign debt yield x (annualized standard deviation of Country A's equity index / annualized standard deviation of Country A's sovereign bond market or index)

Annualized standard deviation is a measure of volatility. The rationale behind comparing the volatility of the stock and sovereign bond markets for a specific country in this method is that they compete with each other for investor funds. Thus, if a country's stock market is significantly more volatile than the sovereign bond market, its CRP would be on the higher side, implying that investors would demand a larger premium to invest in the country's equity market (compared to the bond market) as it would be deemed riskier.

Note that for the purposes of this calculation, a country's sovereign bonds should be denominated in a currency where a default-free entity exists, such as the US dollar or Euro.

Since the risk premium calculated in this manner is applicable to equity investing, CRP in this case is synonymous with Country Equity Risk Premium, and the two terms are often used interchangeably.

Example:

• Yield on Country A's 10-year USD-denominated sovereign bond = 6.0%
• Yield on US 10-year Treasury bond = 2.5%
• Annualized standard deviation for Country A's benchmark equity index = 30%
• Annualized standard deviation for Country A's USD-denominated sovereign bond index = 15%

Country (Equity) Risk Premium for Country A = (6.0% - 2.5%) x (30% / 15%) =7.0%

Countries With the Highest CRP

Aswath Damodaran, finance professor at NYU's Stern School of Business, maintains a public database of his CRP estimates that are widely used in the finance industry. As of April 2020, the countries with the highest CRPs are shown in the table below. The table displays total equity risk premium in the second column and CRP in the third column. As noted earlier, CRP calculation entails estimating the risk premium for a mature market and adding a default spread to it.

Damodaran assumes the risk premium for a mature equity market at 5.23% (as of July 1, 2020). Thus Angola has a CRP of 25.77% and a total equity risk premium of 31.78% (22.14% + 6.01%).

Incorporating CRP into the CAPM

The Capital Asset Pricing Model (CAPM) can be adjusted to reflect the additional risks of international investing. The CAPM details the relationship between systematic risk and expected return for assets, particularly stocks. The CAPM model is widely used throughout the financial services industry for the purposes of pricing of risky securities, generating subsequent expected returns for assets, and calculating capital costs.

CAPM Function:

r a = r f + β a ( r m − r f ) where: r f = risk-free rate of return β a = beta of the security r m = expected market return \begin{aligned} &\text{r}_\text{a} = \text{r}_\text{f} + \beta_\text{a} ( \text{r}_\text{m} - \text{r}_\text{f} ) \\ &\textbf{where:} \\ &\text{r}_\text{f} = \text{risk-free rate of return} \\ &\beta_\text{a} = \text{beta of the security} \\ &\text{r}_\text{m} = \text{expected market return} \\ \end{aligned} ​ra​=rf​+βa​(rm​−rf​)where:rf​=risk-free rate of returnβa​=beta of the securityrm​=expected market return​

There are three approaches for incorporating a Country Risk Premium into the CAPM so as to derive an Equity Risk Premium that can be used to assess the risk of investing in a company located in a foreign country.

1. The first approach assumes that every company in the foreign country is equally exposed to country risk. While this approach is commonly used, it makes no distinction between any two companies in the foreign country, even if one is a huge export-oriented firm and the other is a small local business. In such cases,CRP would be added to the mature market expected return, so that CAPM would be:

R e = R f + β ( R m − R f ) + CRP \begin{aligned} &\text{R}_\text{e} = \text{R}_\text{f} + \beta ( \text{R}_\text{m} - \text{R}_\text{f} ) + \text{CRP} \\ \end{aligned} ​Re​=Rf​+β(Rm​−Rf​)+CRP​

1. The second approach assumes that a company's exposure to country risk is similar to its exposure to other market risk. Thus,

R e = R f + β ( R m − R f + CRP ) \begin{aligned} &\text{R}_\text{e} = \text{R}_\text{f} + \beta ( \text{R}_\text{m} - \text{R}_\text{f} + \text{CRP} ) \\ \end{aligned} ​Re​=Rf​+β(Rm​−Rf​+CRP)​

1. The third approach considers country risk as a separate risk factor, multiplying CRP with a variable (generally denoted by lambda or λ). In general terms, a company that has significant exposure to a foreign country - by virtue of getting a large percentage of its revenues from that country, or having a substantial share of its manufacturing located there - would have a higher λ value than a company that is less exposed to that country.

Example: Continuing with the example cited earlier, what would be the cost of equity for a company that is considering setting up a project in Country A, given the following parameters?

CRP for Country A = 7 . 0 % R f = risk-free rate = 2 . 5 % R m = expected market return = 7 . 5 % Project Beta = 1 . 2 5 Cost of equity = R f + β ( R m − R f + CRP ) Cost of equity = 2 . 5 % + 1 . 2 5   ( 7 . 5 % − 2 . 5 % + 7 . 0 ) \begin{aligned} &\text{CRP for Country A} = 7.0\% \\ &\text{R}_\text{f} = \text{risk-free rate} = 2.5\% \\ &\text{R}_\text{m} = \text{expected market return} = 7.5\% \\ &\text{Project Beta} = 1.25 \\ &\text{Cost of equity} = \text{R}_\text{f} + \beta ( \text{R}_\text{m} - \text{R}_\text{f} + \text{CRP} ) \\ &\phantom{\text{Cost of equity}} = 2.5\% + 1.25 \ ( 7.5\% - 2.5\% + 7.0 )\\ &\phantom{\text{Cost of equity}} = 17.5\% \end{aligned} ​CRP for Country A=7.0%Rf​=risk-free rate=2.5%Rm​=expected market return=7.5%Project Beta=1.25Cost of equity=Rf​+β(Rm​−Rf​+CRP)Cost of equity=2.5%+1.25 (7.5%−2.5%+7.0)​

Country Risk Premium - Pros and Cons

While most would agree that country risk premia help by representing that a country, such as Myanmar, would present more uncertainty than, say, Germany, some opponents question the utility of CRP. Some suggest that country risk is diversifiable. With regard to the CAPM described above, along with other risk and return models—which entail non-diversifiable market risk—the question remains as to whether additional emerging market risk is able to be diversified away. In this case, some argue no additional premia should be charged.

Others believe the traditional CAPM can be broadened into a global model, thus incorporating various CRPs. In this view, a global CAPM would capture a single global equity risk premium, relying on an asset’s beta to determine volatility. A final major argument rests on the belief that country risk is better reflected in a company’s cash flows than the utilized discount rate. Adjustments for possible negative events within a nation, such as political and/or economic instability, would be worked into expected cash flows, therefore eliminating the need for adjustments elsewhere in the calculation.

Overall though, the CRP serves a useful purpose by quantifying the higher return expectations for investments in foreign jurisdictions, which undoubtedly have an additional layer of risk compared with domestic investments. As of 2020, the risks of overseas investing appear to be on the rise, given the increase in trade tensions and other concerns globally.

BlackRock, the world's largest asset manager, has a "Geopolitical Risk Dashboard" that analyzes leading risks. As of Dec. 2020, these risks included: European fragmentation, US-China competition, South Asia tensions, global trade tensions, North Korea conflict, major terror and cyberattacks, Gulf tensions, and LatAm policy. While some of these issues may well be resolved in time, it would seem prudent to account for these risk factors in any evaluation of returns from a project or investment located in a foreign country.

What is measured by the project's impact on uncertainty regarding the firm's future returns?

Which of the following is measured by the variability of the project's expected returns?

Which of the following statements about the payback method of capital budgeting is correct?

When dealing with market risk diversification is totally ignored?