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Measuring Country Risk
by Aswath Damodaran
Executive Summary
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 investorsi.e., active investors who hold large positions in the stockhave 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 relationshipsay
Braziland 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.
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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 flowsthis 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 premium
Emerging market
= Equity risk premium
Mature 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 countrys
debt by a ratings agency (S&P, Moodys, 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 riskthe stability of a
countrys 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 Moodys and the ten-year Brazilian ten-year dollar-denominated 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%, 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 deviation
Country X
= Standard deviation
Country X
Standard deviation
US
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 premium
Country X
= Risk premium
US
Relative standard deviation
Country 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%,
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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:
Equity risk premium
Brazil
= 4.79% 25.83% 15.27% = 8.10%
The country risk premium can be isolated as follows:
Country risk premium
Brazil
= 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
measure the premium for default risk. Intuitively, we would expect the country equity risk premium to be
larger than the country default risk 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

Country bond
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 premium
Brazil
= 2.15% 25.83% 12.55% = 4.43%
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 relative 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 externallythe 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
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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 rates
6
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 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.
More Info
Book:
Falaschetti, Dominic, and Michael Annin Ibbotson (eds). Stocks, Bonds, Bills and Inflation. Chicago, IL:
Ibbotson Associates, 1999.
Articles:
Booth, Laurence. Estimating the equity risk premium and equity costs: New ways of looking
at old data. Journal of Applied Corporate Finance 12:1 (Spring 1999): 100112. Online at:
dx.doi.org/10.1111/j.1745-6622.1999.tb00665.x
Chan, K. C., G. Andrew Karolyi, and Ren M. Stulz. Global financial markets and the risk
premium on US equity. Journal of Financial Economics 32:2 (October 1992): 137167. Online at:
dx.doi.org/10.1016/0304-405X(92)90016-Q
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 26:4 (Winter 1997): 8190. Online at:
www.jstor.org/stable/3666130
Report:
Damodaran, Aswath. Equity risk premiums (ERP): Determinants, estimation and implications.
October 2008. Online at: www.stern.nyu.edu/~adamodar/pdfiles/papers/ERPfull.pdf
Notes
1 The process by which country ratings are obtained is explained on the S&P website at
www2.standardandpoors.com/aboutcreditratings
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2 These yields were as of January 1, 2008. While this is a market rate and reflects current expectations,
country bond spreads are extremely volatile and can shift significantly from day to day. To counter this
volatility, the default spread can be normalized by averaging the spread over time or by using the average
default spread for all countries with the same rating as Brazil in early 2008.
3 If a country has a sovereign rating and no dollar-denominated bonds, we can use a typical spread based
upon the rating as the default spread for the country. These numbers are available on my website at
www.damodaran.com
4 If the dependence on historical volatility is troubling, the options market can be used to get implied
volatilities for both the US market (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 emerging markets is a long-term expected growth rate. For
Brazilian stocks, I used the average consensus estimate of growth in earnings for the largest Brazilian
companies which have ADRs listed on them. This estimate may be biased as a consequence.
See Also
Best Practice
Credit Ratings
Measuring Company Exposure to Country Risk
Political Risk: Countering the Impact on Your Business
PublicPrivate Partnerships in Emerging Markets
Understanding the Role of Diversification
Checklists
Comparative and International Financial Regulation
How to Use Credit Rating Agencies
Understanding the Relationship between the Discount Rate and Risk
Thinkers
Prince Al-Walid bin Talal
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