Aswath Damodaran 13 Two Ways of Estimating Country Equity Risk Premiums for

Aswath damodaran 13 two ways of estimating country

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Aswath Damodaran 13 Two Ways of Estimating Country Equity Risk Premiums for other markets.. Default spread on Country Bond : In this approach, the country equity risk premium is set equal to the default spread of the bond issued by the country (but only if it is denominated in a currency where a default free entity exists. Brazil was rated B2 by Moody’s and the default spread on the Brazilian dollar denominated C.Bond at the end of August 2004 was 6.01%. (10.30%-4.29%) Relative Equity Market approach : The country equity risk premium is based upon the volatility of the market in question relative to U.S market. Total equity risk premium = Risk Premium US * σ Country Equity / σ US Equity Using a 4.82% premium for the US, this approach would yield: Total risk premium for Brazil = 4.82% (34.56%/19.01%) = 8.76% Country equity risk premium for Brazil = 8.76% - 4.82% = 3.94% (The standard deviation in weekly returns from 2002 to 2004 for the Bovespa was 34.56% whereas the standard deviation in the S&P 500 was 19.01%)
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Aswath Damodaran 14 And a third approach Country ratings measure default risk. While default risk premiums and equity risk premiums are highly correlated, one would expect equity spreads to be higher than debt spreads. Another is to multiply the bond default spread by the relative volatility of stock and bond prices in that market. In this approach: Country Equity risk premium = Default spread on country bond* σ Country Equity / σ Country Bond Standard Deviation in Bovespa (Equity) = 34.56% Standard Deviation in Brazil C-Bond = 26.34% Default spread on C-Bond = 6.01% Country Equity Risk Premium = 6.01% (34.56%/26.34%) = 7.89 %
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Aswath Damodaran 15 Can country risk premiums change? Updating Brazil in January 2004 Brazil’s financial standing and country rating improved dramatically towards the end of 2004. Its rating improved to B1. In January 2005, the interest rate on the Brazilian C-Bond dropped to 7.73%. The US treasury bond rate that day was 4.22%, yielding a default spread of 3.51% for Brazil. Standard Deviation in Bovespa (Equity) = 25.09% Standard Deviation in Brazil C-Bond = 15.12% Default spread on C-Bond = 3.51% Country Risk Premium for Brazil = 3.51% (25.09%/15.12%) = 5.82%
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Aswath Damodaran 16 From Country Equity Risk Premiums to Corporate Equity Risk premiums Approach 1: Assume that every company in the country is equally exposed to country risk. In this case, E(Return) = Riskfree Rate + Country ERP + Beta (US premium) Implicitly, this is what you are assuming when you use the local Government’s dollar borrowing rate as your riskfree rate. Approach 2: Assume that a company’s exposure to country risk is similar to its exposure to other market risk. E(Return) = Riskfree Rate + Beta (US premium + Country ERP) Approach 3: Treat country risk as a separate risk factor and allow firms to have different exposures to country risk (perhaps based upon the proportion of their revenues come from non-domestic sales) E(Return)=Riskfree Rate+ β (US premium) + λ ( Country ERP) ERP: Equity Risk Premium
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Aswath Damodaran 17 Estimating Company Exposure to Country Risk: Determinants Source of revenues
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  • Interest, Risk premium, equity risk premium

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