The Country Risk Premium (CRP) is characterized as the additional returns that the investor expects in order to bear the risk of investing in international markets in comparison with the domestic market. Because of the plethora of geopolitical and macroeconomic risk factors that need to be addressed, overseas investment opportunities are followed by greater risk. Putting resources into unfamiliar nations has become more normal now than it was previously. A United States speculator may jump at the chance to put resources into the protection of Asian business sectors, say China or India. These elevated risks make investors wary of investing abroad and, as a consequence, require a risk premium to invest in them. The national risk premium for emerging economies is typically higher than for developed nations.
The international situation isn’t the equivalent in various locales of the world. There are chances related with each economy, and Country Risk Premium is a proportion of this danger. Nation hazard envelops various components, 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).
Since country risk is widely agreed to be non-diversifiable, the amount of the risk-free rate and the equity risk premium (developed market) must be applied to the country risk premium. The risk of a nation is a crucial factor to be taken into consideration when investing in foreign markets. Most public fare improvement organizations have top to bottom dossiers on the dangers related with working together in different nations around the globe. Because the assurance of returns on investment in international markets is usually lower than in the case of domestic markets, it is vital here.
Country Risk Premium can significantly affect valuation and corporate money figurings. The computation of CRP includes assessing the danger premium for a developed market, for example, the United States, and adding a default spread to it. There are two principal methods to calculate country risk premium: (a) the sovereign yield method and (b) the equity risk premium method.
Sovereign yield method: The sovereign yield method (also referred to as the bond yield spread method) calculates the country risk premium as the difference between the yield on government bonds of developing countries and the yield on government bonds of the same maturity of developed country same-currency.
CRP = YF – YD
CRP is the country risk premium,
YF is the yield on emerging country government bonds, and
YD is the yield on developed country government bonds.
The currency of the bonds and their yield to maturity must be the same to arrive at an accurate estimate of CRP.
Sovereign yield adjusted for equity/debt volatility:
Some practitioners argue that the differential return must be balanced according to the volatility ratio of the stock market in the developing country and the volatility of the sovereign bond market, as follows:
CRP = (YF – YD) × σE / σG
Where σE is the standard deviation of the equity market returns and σG is the standard deviation of the government bonds yield. The equity risk premium approach contrasts the emerging market’s market risk premium (MRP) with the established market’s market risk premium.
Nonetheless, there are downsides to the two techniques. In the event that a nation is seen to have an expanded danger of defaulting on its sovereign obligation, yields on its sovereign obligation would take off, just like the case for various European nations in the second decade of the current thousand years. There are three approaches that can be followed using the capital asset pricing model in modifying the development market required rate of return for the country risk premium. The spread of sovereign debt yields in such situations may not inherently be a useful predictor of the risks faced by investors in those countries. Concerning the value hazard technique, it might fundamentally downplay CRP if a nation’s market instability is anomalous low in view of market illiquidity and less open organizations, which might be normal for some wilderness markets.
Calculating Country Risk Premium:
Country Risk Premium (for Country A) = Spread on Country A’s sovereign debt yield x (annualized standard deviation of Country A’s equity index / annualized standard deviation of Country A’s sovereign bond market or index)
Country (Equity) Risk Premium for Country A = (6.0% – 2.5%) × (30% / 15%) = 7.0%
In the theory of CAPM (Capital Asset Pricing Model), country risk premium finds most use. A CAPM model is a measure of return on equity considering the non-systematic risk or firm risk where,
Re = Rf + β × (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.
Thus, if the stock market of a country is substantially more volatile than the sovereign bond market, its CRP would be on the higher side, meaning that investors would need a greater premium to invest in the equity market of the country (compared to the bond market) because it would be considered riskier. For the purposes of this calculation, the sovereign bonds of a country should be denominated in a currency in which a default-free body, such as the US dollar or the Euro, exists.