Measuring Country Risk by Aswath Damodaran
• As companies and investors globalize and financial markets expand around the
world, we are increasingly faced with estimation questions about the risk associated
with this globalization.
• When investors invest in Petrobras, Gazprom and China Power, they may be rewarded
with higher returns, but they are also exposed to additional risk.
• When US and European multinationals push for growth in Asia and Latin America,
they are clearly exposed to the political and economic turmoil that often characterize
these markets.
• In practical terms, how, if at all, should we adjust for this additional risk? We review
the discussion on country risk premiums and how to estimate them.
INTRODUCTION
Two key questions must be addressed when
investing in emerging markets in Asia,
Latin America, and Eastern Europe. The
first relates to whether we should impose
an additional risk premium when valuing
equities in these markets. As we will see,
the answer will depend upon whether we
view markets to be open or segmented
and whether we believe the risk can be
diversified away. The second question
relates to estimating an equity risk
premium for emerging markets.
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?
Of course! But that does not automatically
imply that there should be an additional
risk premium charged when investing
in those markets. Two arguments are
generally used against adding an additional
premium.
Country risk can be diversified away: If
the additional risk of investing in Malaysia
or Brazil can be diversified away,
then there should be no additional risk
premium charged. But for country risk to
be diversifiable, two conditions must be
met:
1 The marginal investors—i.e., active
investors who hold large positions in the
stock—have to be globally diversified. If
the marginal investors are either unable
or unwilling to invest globally, companies will have to diversify their
operations across countries, which is a
much more difficult and expensive
exercise.
2 All or much of country risk should be
country specific. In other words, there
should be low correlation across
markets. If the returns across countries
are positively correlated, country risk
has a market risk component, is not
diversifiable, and can command a premium. Whereas studies in the 1970s
indicated low or no correlation across
markets, increasing diversification on
the part of both investors and companies
has increased the correlation numbers.
This is borne out by the speed with which
troubles in one market can spread to a
market with which it has little or no
obvious relationship—say Brazil—and
this contagion effect seems to become
stronger during crises.
Given that both conditions are difficult
to meet, we believe that on this basis,
country risk should command a risk
premium.
The expected cash flows for country risk
can be adjusted: This second argument
used against adjusting for country risk
is that it is easier and more accurate
to adjust the expected cash flows for the
risk. However, adjusting the cash flows to
reflect expectations about dire scenarios,
such as nationalization or an economic
meltdown, is not risk adjustment. Making
the risk adjustment to cash flows requires
the same analysis that we will employ
to estimate the risk adjustment to discount
rates.
ESTIMATING A COUNTRY RISK
PREMIUM
If country risk is not diversifiable, either
because the marginal investor is not globally diversified or because the risk is
correlated across markets, we are left with
the task of measuring country risk and
estimating country risk premiums. In this
section, we will consider two approaches
that can be used to estimate country risk
premiums. One approach builds on historical risk premiums and can be viewed as the
historical risk premium plus approach. In
the other approach, we estimate the equity
risk premium by looking at how the market
prices stocks and expected cash flows – this
is the implied premium approach.
Historical Premium Plus
Most practitioners, when estimating risk
premiums in the United States, look at the
past. Consequently, we look at what we
would have earned as investors by investing
in equities as opposed to investing in riskless investments. With emerging markets,
we will almost never have access to as much
historical data as we do in the United
States. If we combine this with the high
volatility in stock returns in such markets,
the conclusion is that historical risk premiums can be computed for these markets,
but they will be useless because of the large
standard errors in the estimates. Consequently, many analysts build their equity
risk premium estimates for emerging
markets from mature market historical risk
premiums.
Equity risk premiumEmerging market =
Equity risk premiumMature market + Country risk premium
To estimate the base premium for a
mature equity market, we will make the
argument that the US equity market is a
mature market and that there is sufficient historical data in the United States
to make a reasonable estimate of the risk
premium. Using the historical data for the
United States, we estimate the geometric
average premium earned by stocks over
treasury bonds of 4.79% between 1928 and
2007. To estimate the country risk premium, we can use one of three approaches:
Country Bond Default Spreads
One of the simplest and most easily accessible country risk measures is the rating
assigned to a country’s debt by a ratings
agency (S&P, Moody’s, and IBCA all rate
countries). These ratings measure default
risk (rather than equity risk), but they are
affected by many of the factors that drive
equity risk—the stability of a country’s currency, its budget and trade balances and its
political stability, for instance.1 The other
advantage of ratings is that they can be
used to estimate default spreads over a
riskless rate. For instance, Brazil was
rated Ba1 in September 2008 by Moody’s
and the ten-year Brazilian ten-year dollardenominated bond was priced to yield
5.95%, 2.15% more than the interest rate
(3.80%) on a ten-year US treasury bond at
the same time.2 Analysts who use default
spreads as measures of country risk typically add them on to the cost of both equity
and debt of every company traded in that
country. If we assume that the total equity
risk premium for the United States
and other mature equity markets is 4.79%,
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the risk premium for Brazil would be
6.94%.3
Relative Standard Deviation
There are some analysts who believe that
the equity risk premiums of markets should
reflect the differences in equity risk, as
measured by the volatilities of equities in
these markets. A conventional measure
of equity risk is the standard deviation in
stock prices; higher standard deviations are
generally associated with more risk. If we
scale the standard deviation of one market
against another, we obtain a measure of
relative risk.
Relative standard deviationCountry X =
冢 Standard deviation
Standard deviationCountry X
US
冣
This relative standard deviation when
multiplied by the premium used for US
stocks should yield a measure of the total
risk premium for any market.
Equity risk premiumCountry X =
spread. To address the issue of how much
higher, we look at the volatility of the equity
market in a country relative to the volatility
of the bond market used to estimate the
spread. This yields the following estimate
for the country equity risk premium.
Country risk premium =
Country default spread ×
Equity risk premiumBrazil = 4.79% ×
冢 15.27% 冣 = 8.10%
25.83%
The country risk premium can be isolated as follows:
Country risk premiumBrazil = 8.10% − 4.79% = 3.31%
While this approach has intuitive
appeal, there are problems with comparing
standard deviations computed in markets
with widely different market structures and
liquidity. There are very risky emerging
markets that have low standard deviations
for their equity markets because the
markets are illiquid. This approach will
understate the equity risk premiums in
those markets.
Default Spreads and Relative
Standard Deviations
The country default spreads that come with
country ratings provide an important first
step, but still only measures the premium
for default risk. Intuitively, we would
expect the country equity risk premium to
be larger than the country default risk
Country bond
冣
To illustrate, consider again the case of
Brazil. As noted earlier, the default spread
on the Brazilian dollar-denominated bond
in September 2008 was 2.15%, and the
annualized standard deviation in the
Brazilian equity index over the previous
year was 25.83%. Using two years of weekly
returns, the annualized standard deviation
in the Brazilian dollar denominated
ten-year bond was 12.55%.5 The resulting
country equity risk premium for Brazil is
as follows:
Additional equity risk premiumBrazil =
2.15%
(Risk premiumUS × Relative standard deviationCountry X)
Assume, for the moment, that we are
using a mature market premium for the
United States of 4.79%. The annualized
standard deviation in the S&P 500 between
2006 and 2008, using weekly returns, was
15.27%, whereas the standard deviation in
the Bovespa (the Brazilian equity index)
over the same period was 25.83%.4
Using these values, the estimate of a total
risk premium for Brazil would be as
follows:
冢y
冢 12.55% 冣 = 4.43%
25.83%
Unlike the equity standard deviation
approach, this premium is in addition to a
mature market equity risk premium. Note
that this country risk premium will increase
if the country rating drops or if the relative
volatility of the equity market increases.
It is also in addition to the equity risk
premium for a mature market. Thus, the
total equity risk premium for Brazil using
this approach and a 4.79% premium for the
United States would be 9.22%.
Both this approach and the previous one
use the standard deviation in equity of a
market to make a judgment about country
risk premium, but they measure it relatively to different bases. This approach uses
the country bond as a base, whereas the
previous one uses the standard deviation
in the US market. It also assumes that
investors are more likely to choose between
Brazilian government bonds and Brazilian
equity, whereas the previous approach
assumes that the choice is across equity
markets.
Implied Equity Premiums
There is an alternative approach to estimating risk premiums that does not require
historical data or corrections for country
risk but does assume that the market,
overall, is correctly priced. Consider, for
instance, a very simple valuation model for
stocks:
Value =
Expected dividends next period
(Required return on equity − Expected growth rate)
This is essentially the present value of
dividends growing at a constant rate. Three
of the four inputs in this model can be
obtained externally—the current level of
the market (value), the expected dividends
next period, and the expected growth rate
in earnings and dividends in the long term.
The only “unknown” is then the required
return on equity; when we solve for it, we
get an implied expected return on stocks.
Subtracting out the risk-free rate will yield
an implied equity risk premium. We can
extend the model to allow for dividends to
grow at high rates, at least for short
periods.
The advantage of the implied premium
approach is that it is market-driven and
current, and it does not require any historical data. Thus, it can be used to estimate
implied equity premiums in any market.
For instance, the equity risk premium for
the Brazilian equity market on September
9, 2008, was estimated from the following
inputs. The index (Bovespa) was at 48,345
and the current cash flow yield on the index
was 5.41%. Earnings in companies in the
index are expected to grow 9% (in US dollar
terms) over the next five years, and 3.8%
thereafter. These inputs yield a required
return on equity of 10.78%, which when
compared to the treasury bond rate of
3.80% on that day results in an implied
equity premium of 6.98%. For simplicity,
we have used nominal dollar expected
growth rates6 and treasury bond rates, but
this analysis could have been done entirely
in the local currency. We can decompose
this number into a mature market equity
risk premium and a country-specific
equity risk premium by comparing it to
the implied equity risk premium for a
mature equity market (the United States,
for instance).
• Implied equity premium for Brazil (see
above) = 6.98%.
• Implied equity premium for the United
States in September 2008 = 4.54%.
• Country specific equity risk premium for
Brazil = 2.44%.
This approach can yield numbers very
different from the other approaches,
because they reflect market prices (and
views) today.
CONCLUSION
As companies expand operations into
emerging markets and investors search for
investment opportunities in Asia and Latin
America, they are also increasingly exposed
to additional risk in these countries. While
it is true that globally diversified investors
can eliminate some country risk by
diversifying across equities in many countries, the increasing correlation across
“Forget about winning and losing; forget about pride and pain. Let your opponent graze your skin and you
smash into his flesh; let him smash into your flesh and you fracture his bones; let him fracture your bones and
you take his life. Do not be concerned with escaping safely - lay your life before him.” Bruce Lee
Book:
Falaschetti, Dominic, and Michael Annin Ibbotson (eds). Stocks, Bonds, Bills and
Inflation. Chicago, IL: Ibbotson Associates, 1999.
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Booth, Laurence. “Estimating the equity risk premium and equity costs: New ways of
looking at old data.” Journal of Applied Corporate Finance 12:1 (1999): 100–112.
Chan, K. C., G. A. Karolyi, and R. M. Stulz. “Global financial markets and the risk
premium on U.S. equity.” Journal of Financial Economics 32:2 (1992): 137–167.
Indro, D. C., and W. Y. Lee, “Biases in arithmetic and geometric averages as estimates
of long-run expected returns and risk premium.” Financial Management 26 (1997):
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Report:
Damodaran, A. “Equity risk premiums: Determinants, estimation and implications.”
Working Paper, SSRN.com, 2008. Online at: pages.stern.nyu.edu/~adamodar/
pdfiles/papers/ERPfull.pdf
NOTES
by using the average default spread for all
1 The process by which country ratings are obtained
countries with the same rating as Brazil in early
is explained on the S&P website at
www.ratings.standardpoor.com/criteria/
index.htm
2 These yields were as of January 1, 2008. While this
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2008.
3 If a country has a sovereign rating and no dollardenominated bonds, we can use a typical spread
(about 20%) and for the Bovespa (about 38%).
5 Both standard deviations are computed on
returns; returns on the equity index and returns
on the ten-year bond.
6 The input that is most difficult to estimate for
based upon the rating as the default spread for the
emerging markets is a long-term expected growth
is a market rate and reflects current expectations,
country. These numbers are available on my
rate. For Brazilian stocks, I used the average
country bond spreads are extremely volatile and
website at www.damodaran.com
consensus estimate of growth in earnings for the
can shift significantly from day to day. To counter
4 If the dependence on historical volatility is
largest Brazilian companies which have ADRs
this volatility, the default spread can be
troubling, the options market can be used to
listed on them. This estimate may be biased as a
normalized by averaging the spread over time or
get implied volatilities for both the US market
consequence.
“You cannot control what happens to you, but you can control your attitude toward what happens to you, and
in that, you will be mastering change rather than allowing it to master you.” Brian Tracy
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markets suggests that country risk cannot
be entirely diversified away. To estimate
the country risk premium, we considered
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
cash flows.