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Asset Management Best Practice

Measuring Company Exposure to Country Risk

by Aswath Damodaran

Table of contents

Executive Summary

Introduction

If we accept the proposition of country risk, the next question that we have to address relates to the exposure of individual companies to country risk. Should all companies in a country with substantial country risk be equally exposed to country risk? While intuition suggests that they should not, we will begin by looking at standard approaches that assume that they are. We will follow up by scaling country risk exposure to established risk parameters such as betas (β), and complete the discussion with an argument that individual companies should be evaluated for exposure to country risk.

The Bludgeon Approach

The simplest assumption to make when dealing with country risk, and the one that is most often made, is that all companies in a market are equally exposed to country risk. The cost of equity for a firm in a market with country risk can then be written as:

Cost of equity = Risk-free rate + β (Mature market premium) + Country risk premium

Thus, for Brazil, where we have estimated a country risk premium of 4.43% from the melded approach, each company in the market will have an additional country risk premium of 4.43% added to its expected returns. For instance, the costs of equity for Embraer, an aerospace company listed in Brazil, with a beta1 of 1.07 and Embratel, a Brazilian telecommunications company, with a beta of 0.80, in US dollar terms would be:

Cost of equity for Embraer = 3.80% + 1.07 (4.79%) + 4.43% = 13.35%

Cost of equity for Embratel = 3.80% + 0.80 (4.79%) + 4.43% = 12.06%

Note that the risk-free rate that we use is the US treasury bond rate (3.80%), and that the 4.79% figure is the equity risk premium for a mature equity market (estimated from historical data in the US market). It is also worth noting that analysts estimating the cost of equity for Brazilian companies, in US dollar terms, often use the Brazilian ten-year dollar-denominated rate as the risk-free rate. This is dangerous, since it is often also accompanied with a higher risk premium, and ends up double counting risk.

The Beta Approach

For those investors who are uncomfortable with the notion that all companies in a market are equally exposed to country risk, a fairly simple alternative is to assume that a company’s exposure to country risk is proportional to its exposure to all other market risk, which is measured by the beta. Thus, the cost of equity for a firm in an emerging market can be written as follows:

Cost of equity = Risk-free rate + β (Mature market premium + Country risk premium)

In practical terms, scaling the country risk premium to the beta of a stock implies that stocks with betas above 1.00 will be more exposed to country risk than stocks with a beta below 1.00. For Embraer, with a beta of 1.07, this would lead to a dollar cost of equity estimate of:

Cost of equity for Embraer = 3.80% + 1.07 (4.79% + 4.43%) = 13.67%

For Embratel, with its lower beta of 0.80, the cost of equity is:

Cost of equity for Embratel = 3.80% + 0.80 (4.79% + 4.43%) = 11.18%

The advantage of using betas is that they are easily available for most firms. The disadvantage is that while betas measure overall exposure to macroeconomic risk, they may not be good measures of country risk.

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Further reading

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): 100–112. Online at: dx.doi.org/10.1111/j.1745-6622.1999.tb00665.x
  • Chan, K. C., G. Andrew Karolyi, and René M. Stulz. “Global financial markets and the risk premium on US equity.” Journal of Financial Economics 32:2 (October 1992): 137–167. Online at: dx.doi.org/10.1016/0304-405X(92)90016-Q
  • Damodaran, Aswath. “Country risk and company exposure: Theory and practice.” Journal of Applied Finance 13:2 (Fall/Winter 2003): 64–78.
  • Godfrey, Stephen, and Ramon Espinosa. “A practical approach to calculating the cost of equity for investments in emerging markets.” Journal of Applied Corporate Finance 9:3 (Fall 1996): 80–90. Online at: dx.doi.org/10.1111/j.1745-6622.1996.tb00300.x
  • Indro, Daniel C., and Wayne Y. Lee. “Biases in arithmetic and geometric averages as estimates of long-run expected returns and risk premium.” Financial Management 26:4 (Winter 1997): 81–90. Online at: www.jstor.org/stable/3666130
  • Stulz, René M. “Globalization, corporate finance, and the cost of capital.” Journal of Applied Corporate Finance 12:3 (Fall 1999): 8–25. Online at: dx.doi.org/10.1111/j.1745-6622.1999.tb00027.x

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