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.

b.     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.

c.     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.