Estimating the Country Risk (Country Equity Premium)

In developed nations, the beta of a stock adequately captures the country risk (Historical evidence). However, this doesn’t hold true for developing nations. Therefore, the calculation of cost of equity using CAPM requires adding a country risk spread to the market risk premium. This is also called the country equity premium.

The Country Risk Premium can be calculated using the following methods:

Method 1

The first method is to use the Sovereign Yield Spread as the country spread.

Sovereign Yield Spread = Country’s Government Bond Yield – Treasury Bond Yield in a Developed Country

This method is considered too rough and is not generally used.

Method 2

The second method is more robust and calculates the country equity premium as follows:

$Country\ Equity\ Premium = Country\ Default\ Spread \frac{\sigma_{Equity} }{\sigma_{Country\ Bond}}$