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    Country Risk Premium

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    Sandia Espejo
    Country Risk Premium is the additional return investors demand to compensate for higher risk from investing in foreign countries versus domestic markets. It is generally higher for developing than developed nations. Country risk considers factors like political instability, economic risks, sovereign debt, currency fluctuations, and regulations. Estimating CRP involves comparing sovereign debt yields between countries or equity market volatility. The CRP formula uses sovereign bond spreads and equity/bond index volatility to calculate the premium.

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    Country Risk Premium

    Uploaded by

    Sandia Espejo
    77 views3 pages
    Country Risk Premium is the additional return investors demand to compensate for higher risk from investing in foreign countries versus domestic markets. It is generally higher for developing than developed nations. Country risk considers factors like political instability, economic risks, sovereign debt, currency fluctuations, and regulations. Estimating CRP involves comparing sovereign debt yields between countries or equity market volatility. The CRP formula uses sovereign bond spreads and equity/bond index volatility to calculate the premium.

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    Country Risk Premium is the additional return investors demand to compensate for higher risk from investing in foreign countries versus domestic markets. It is generally higher for developing than developed nations. Country risk considers factors like political instability, economic risks, sovereign debt, currency fluctuations, and regulations. Estimating CRP involves comparing sovereign debt yields between countries or equity market volatility. The CRP formula uses sovereign bond spreads and equity/bond index volatility to calculate the premium.

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    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    77 views3 pages

    Country Risk Premium

    Uploaded by

    Sandia Espejo
    Country Risk Premium is the additional return investors demand to compensate for higher risk from investing in foreign countries versus domestic markets. It is generally higher for developing than developed nations. Country risk considers factors like political instability, economic risks, sovereign debt, currency fluctuations, and regulations. Estimating CRP involves comparing sovereign debt yields between countries or equity market volatility. The CRP formula uses sovereign bond spreads and equity/bond index volatility to calculate the premium.

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    © All Rights Reserved
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    COUNTRY RISK PREMIUM

     Descriptions about Country Risk Premium


     It 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.
     It 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.

     Estimating Country Risk Premium


    1. 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.
    2. 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.

     Factors to consider while estimating Country risk premium


     Macroeconomic factors like inflation
     Currency fluctuations
     Fiscal deficit and related policies

     Country Risk Premium Formula

    CRP = Spread on Sovereign Bond Yield * (Risk Estimate on Equity Index Annualized /
    Risk Estimate on Bond Index Annualized)

    Thus, more technically,

    CRP = Spread on Sovereign Bond Yield * Annualized Standard Deviation on Equity


    Index / Annualized Standard Deviation on Bond Index
     Example 1: If a country has an annualized return of 18% and 12.5% on equity and
    bond index, respectively, over a 5-year period, what is the country risk premium?
    The country’s treasury bond has yielded a 3.5% return, whereas sovereign bond has
    a 7% yield on a similar period.

     Example 2: Calculate the CRP with similar yields as in the example above, other than
    the equity index yield, which is 21%.

     Notice that as the equity index yield goes up from 18% to 21%, the CRP increases
    from 5.04% to 5.88%. This can be attributed to the higher volatility in the equity
    market, which has produced a higher return and hence raises the CRP with it.

     Country Risk Premium Calculation & CAPM


     Country risk premium finds most use in the CAPM (Capital Asset Pricing Model)
    theory. A CAPM model is a measure of return on equity considering the non-
    systematic risk or firm risk where,
    Re = Rf + β x (Rm-Rf)
    Re is the return on equity,
    Rf is the risk-free rate,
    Β is the Beta or market risk, and
    Rm is return expected from the market.
     Approaches to estimate Rebased on the inclusion of CRP.
    1. One way to include country risk premium (CRP) is to add it to the risk-free and
    risky asset component. Hence, Re = Rf + β x (Rm-Rf) + CRP
    2. Another way to include CRP in the CAPM model is to make it a function of firm
    risk. Re = Rf + β x (Rm-Rf + CRP)
    - Approach 1 differs from 2 in that Country risk is unconditional addition to every
    firm’s risk-return profile.
    - Example 3: Calculate the return on equity from the following information:
    Risk-Free Rate (Rf): 4%
    Expected Market Return (Rm): 8%
    Firm Beta (β): 1.2
    Country Risk Premium: 5.2%

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