be an additional country risk premium for investing in a Brazilian
or a Chinese company?
It is easy to make the argument that
there is more risk in investing in China and Brazil than there
is in investing in a developed market. It is much more difficult
to show that this translates into an additional country risk
premium. This is because the only risk that should affect the
discount rate is non-diversifiable risk. If we assume that stocks
in emerging markets are lightly correlated with each other and
with developed markets, the risk in these markets should be diversifiable
(by investors in companies, even if companies cannot do it themselves)
and there should be no country risk premium. If, on the other
hand, these markets are highly correlated with each other, there
will be a country risk premium that reflects how sensitive that
market is to global shocks.
Empirically, which view of the world
is right? Two decades ago, when most investors had not discovered
emerging markets, the argument that country risk could be diversified
away had solid backing. Partly as a result of globalization (both
in product and financial markets), the correlation between markets
has steadily risen over time, making it imperative that we consider
country risk explicitly.
If yes, how
would you go about estimating it?
There are three approaches that are
commonly used. One is to find a dollar or euro denominated bond
issued by a country (such as the Brazilian dollar denominated
C-Bond) and comparing the interest rate on this bond to the interest
rate on a riskless bond in the same currency (such as the U.S.
treasury bond). The resulting difference is called a country
bond default spread and is added on to the mature market risk
premium (from the United States). The second is to take the premium
that you charge in the U.S. equity market and scale it by the
relative volatility of the emerging market (volatility of the
emerging market / volatility of the US market). Thus, if the
Brazilian market is twice as volatile as the US market, you would
double the risk premium used in the US. The third is a blended
approach, where you multiply the country bond default spread
by the relative volatility of the equity market in that country
to the country bond (volatility of the equity market/ volatility
of the country bond).
The country risk premium that you
estimate should not be frozen over time. In other words, if you
have a ten-year time horizon in your valuation, your country
risk premium can and often should change over time reflecting
your views of that country.
Once you estimate
the country risk premium, should the same premium be added on for
all companies in that country? If you don't think so, how would
you go about estimating a company's exposure to country risk?
While it is the conventional practice
to add the country risk premium as a constant to every company's
cost of equity, it seems unfair. After all, some companies in
an emerging market (especially those that get the bulk of their
revenues from outside the emerging market) should be less exposed
to country risk that others. One simple way of measuring a company's
exposure to country risk is to look at the percent of revenues
it derives from that market and scale it to what the average
company in the market derives as revenues. This estimate (which
we called lambda) can then be applied to the country-specific
premium to estimate a cost of equity.