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Asset Management Best Practice

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 investors—i.e., active investors who hold large positions in the stock—have 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 relationship—say Brazil—and 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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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
  • 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): 81–90. Online at: www.jstor.org/stable/3666130

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