Download Country Risk Premium

Dick Sweeney
Notes on the “Country Risk Premium”
In finding the required rate of return on equity to use in valuing a foreign project/company, some
analysts habitually add a premium for country risk, or RP c. There is much confusion about the
circumstances under which including RPc makes sense. Further, the costs and benefits of including RP c are
often unclear. These notes clarify these issues. To be concrete, they use the IAI project/company in the
Corning Glassworks: Indonesia case as an illustration, but the analytical points are perfectly general.
Further, to show how the analysis here fits with practical approaches used in the financial industry, quotes
from Merrill Lynch, “The Art and Science of DCF Valuation in Latin America,” are used.
The Required Rate of Return on Equity. A key ingredient in valuing a project/company is the
required rate of return on equity. The large majority of companies use some Asset-Pricing Model (APM).
The most common APM is the Capital Asset Pricing Model (CAPM),
RReq = rf + L (E RM - rf).
The variables are as follows.
RReq: the required rate of return on equity.
rf: the risk-free rate.
L: the beta on the project or company (after the unlevered beta has been levered to incorporate
the target leverage ratio).
(E RM - rf): the risk premium on “the” market (the market index that matters to the equity holders
of the decision making entity).
APMs are developed to apply to all assets, anywhere in the world, whatever the currency involved, and
whatever the country or political risk involved.
Despite this generality, for valuing a foreign project/company, some analysts write the required
rate of return on equity as
RReq = rf + L (E RM - rf) + RPc,
where RPc is the country risk premium. In some cases, adding RPc makes sense, but in many cases it does
not. The trick is to know when.
Local Industry-Country Betas or ADR Betas. Merrill Lynch, in “The Art and Science of DCF
Valuation in Latin America,” discusses how to find an estimate of the beta for the foreign project/company.
It writes:
“Ideally, local market betas of companies in the same industry and country as the one in question
would be used. However, such betas are usually not available. A second-best approach is to use
U.S. market betas of comparable Latin American companies which have listed ADRs [American
Depository Receipts].” From Merrill Lynch, “The Art and Science of DCF Valuation in Latin
America.”
Suppose that Corning decides to investigate the beta risk of dinnerware firms traded on the Jakarta
Stock Exchange (JSE). Suppose there are some—those pure plays that investors look for. Corning can then
regress the rate of return, in USD, of an index of Indonesia dinnerware firms against the U.S. or world
index it uses, or estimate the market model
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RJ,dw,t = a + b RWM,t + ut.
RJ,dw,t is the rate of return in USD of the dinnerware (dw) index of the JSE.
Corning might find that the estimated beta for the dinnerware index is 0.40, or b̂ J,dw = 0.40, rather
than the b̂ JSE = 0.50 that Ms. Scott found in the Robin Corporation case for the overall JSE index in USD.
Because the Indonesia dinnerware industry is likely levered, an unlevered beta would have to be backed out
(a separate problem treated in other Notes).
An alternative that is sometime possible is to use an index of the ADRs of the Indonesia
dinnerware industry. These ADRs, traded in the U.S., and with their prices thus in USD, are claims to
equity shares of Indonesia dinnerware firms. Suppose the rate of return on the ADRs of Indonesia
dinnerware firms is RADR,I,dw,t. Then, Corning might run the regression
RADR,I,dw,t = a + b RWM,t + ut.
Suppose the estimated beta is b̂ ADR,I,dw = 0.42. In general, b̂ dw and b̂ ADR,I,dw will be somewhat different.
(Note we might also have b̂ ADR,I,dw = 0.38 < b̂ dw—there is no presumption that b̂ ADR,I,dw > b̂ dw.) For one
thing, the JSE and the NYSE, if that is where the ADRs trade, are open for very different hours that do not
overlap. Nevertheless, supposing that arbitrage between the JSE and NYSE is not too expensive, we will
often find b̂ dw  b̂ ADR,I,dw—the estimated betas will contain pretty much the same information.
The key point is this: Under these circumstances, there is no case for adding a country risk
premium. Even analysts who favor adding a country risk premium in some situations advise against adding
a risk premium in this case:
“When using exclusively U.S. market (ADR) betas [that is, the index contains only U.S. ADRs on
Indonesia dinnerware companies, and does not for example, also contain U.S. dinnerware
companies], do not explicitly add a country risk premium to the cost of equity calculation. Since
the calculated beta is based on the level of risk of foreign companies versus the U.S. equity market,
it already includes country risk.” From Merrill Lynch, “The Art and Science of DCF Valuation in
Latin America.”
U.S. Betas for the Industry. The JSE may contain no dinnerware firms and there may be no
ADRs for Indonesia dinnerware firms. In this case one might examine the dinnerware industry in the U.S.
The market model regression is then
RUS,dw,t = a + b RWM,t + ut,
where RUS,dw,t is the rate of return in USD of the dinnerware industry in the U.S. Suppose the estimated beta
for the U.S. dinnerware industry is b̂ US,dw = 0.80. Compared to other U.S. industries, the dinnerware beta is
below average.
The estimated beta b̂ US,dw has to be adjusted to reflect the differences in risk between the U.S. and
Indonesia. This is the case where some analysts advocate adding a country risk premium:
“If the analysis is conducted in U.S. dollars and the unlevered beta is calculated using U.S.
comparable companies [emphasis added], the best benchmark for the premium required by the
market for investments in a given country is the actual or estimated spread between 10-year U.S.
Treasuries and a newly issued U.S. dollar-denominated, sovereign, 10-year debt instrument of the
country….” From Merrill Lynch, “The Art and Science of DCF Valuation in Latin America.”
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Betas from a Different EME. For completeness, consider the possibility that Corning can find
no suitable comparables in the U.S. and instead uses and index of Philippine dinnerware firms. The
assumption behind this approach—and the assumption is not always useful—is that an unlevered
dinnerware company is pretty much the same in the Philippines, Indonesia or the U.S., and the only
difference is country and political risk across the three countries. One might examine the dinnerware
industry in the Philippines with the market model regression
RPH,dw,t = a + b RWM,t + ut,
where RPH,dw,t is the rate of return in USD of the dinnerware industry in the Philippines. The estimated beta,
b̂ PH,dw, has to be adjusted to reflect the differences in risk between the Philippines and Indonesia.
“If all of the betas being used are for companies in a different Latin American country than that of
the company being valued, it may be necessary to add an inter-country risk premium (or discount),
which is best estimated as the difference in yields between comparable sovereign debt issues of
the two countries.” From Merrill Lynch, “The Art and Science of DCF Valuation in Latin
America.”
The Risk Premium: Measurement and Problems. Of course, J,dw and US,dw are likely to be
different, and thus the estimated b̂ J,dw, and b̂ US,dw are likely to be different. (Leave leverage aside—suppose
that unlevered betas have been backed out in both cases.) In particular, Indonesia and the U.S. have
different country and political risk. Thus, if a dinnerware beta is estimated for U.S. firms to be applied to an
Indonesia project, some writers recommend using
E Rdw - rf = US,dw (E RWM - rf) + RPInd
to estimate the required rate of return for the IAI dinnerware project in Indonesia. RP Ind is suppose to
capture J,dw (E RWM - rf) - US,dw (E RWM - rf) = (J,dw - US,dw) (E RWM - rf), or
(J,dw - US,dw) (E RWM - rf)  RPInd.
The risk premium approach typically estimates RPInd as the difference between the yields on a
USD bond issued by the government of Indonesia and a comparable U.S. government bond, (y Ind - yUS). In
general, (yInd - yUS) > 0. Depending on conditions, (yInd - yUS) may be 300 to 1000 to 1500 bp.
In the RP approach, a yield differential of say (yInd - yUS) = 500bp implies that
(J,dw - US,dw) (E RWM - rf)  RP = (yInd - yUS) = 500 bp
or for a market risk premium of 5%, or (ERM - rf) = 500bp,
(J,dw - US,dw) = (yInd - yUS) / (E RWM - rf) = 500 bp / (E RWM - rf) = 500bp / 500 bp = 1.
Thus, the risk premium approach implies that for US,dw = .8, then J,dw = 1.8. This does not make sense.
The dinnerware industry in the U.S. has a below average beta. The Indonesia stock market as a whole has a
below average beta. But the risk premium approach claims that the Indonesia dinnerware industry has one
of the highest betas likely to be encountered in the world.
Furthermore, the risk-premium approach is likely to give a beta greater than unity for any
Indonesia industry or company. If all these high beta Indonesia companies are aggregated, this implies that
the Indonesia index should be high beta. But it is not—over the period examined here, it has a beta of
perhaps 0.50.
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