COUNTRY RISK PREMIUM: WHAT IT MEASURE

What is CRP?

Country Risk Premium (CRP) is the additional return or premium demanded by investors to compensate them for the higher risk associated with investing in a foreign country, compared with investing in the domestic market.

Country risk encompasses numerous factors, 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).

There are two commonly used methods of estimating CRP:

Sovereign Debt Method - CRP for a particular country can be estimated by comparing the spread of sovereign debt yields between the country and a mature market like the U.S.

Equity Risk Method - CRP is measured on the basis of the relative volatility of equity market returns between a specific country and a developed nation.

**There are drawbacks to both methods. If a country is perceived to have an increased risk of defaulting on its sovereign debt, yields on its sovereign debt would soar, as was the case for a number of European countries in the second decade of the current millennium. In such cases, the spread on sovereign debt yields may not necessarily be a useful indicator of the risks faced by investors in such countries. As for the equity risk method, it may significantly understate CRP if a country's market volatility is abnormally low because of market illiquidity and fewer public companies, which may be characteristic of some frontier markets.

Calculating Country Risk Premium

A third method of calculating a CRP number that can be used by equity investors overcomes the drawbacks of the above two approaches. For a given Country A, country risk premium can be calculated as:

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)

Example:

Assume the following –

The yield on Country A's 10-year USD-denominated sovereign bond = 6.0%

Yield on US 10-year Treasury bond = 2.5%

Annualized standard deviation for Country A's benchmark equity index = 30% Annualized standard deviation for Country A's USD-denominated sovereign bond index = 15%

Country (Equity) Risk Premium for Country A = (6.0% - 2.5%) x (30% / 15%) =7.0%

Countries with the highest CRP

Aswath Damodaran, Professor of Finance at NYU's Stern School of Business, maintains a public database of his CRP estimates that are widely used in the finance industry. As of January 2019, the countries with the highest Country Risk Premia are shown in the table below. The Table displays the total equity risk premium in the second column and Country (Equity) Risk Premium in the third column. As noted earlier, CRP calculation entails estimating the risk premium for a mature market and adding a default spread to it. Damodaran assumes the risk premium for a mature equity market at 5.96% (as of January 1, 2019). Thus Venezuela has a CRP of 22.14% and a total equity risk premium of 28.10% (22.14% + 5.96%).

 Source: https://www.investopedia.com/terms/c/country-risk-premum.asp