Country risk premium
Valuation & CompsAn addition to the cost of equity meant to capture risks of operating in a particular country that a developed market beta does not price.
Also written: CRP
The risks in question are political instability, restrictions on moving capital out of the country, abrupt changes to tax or regulation, weak enforcement of contracts, and in the extreme expropriation. A beta estimated against a developed market index does not see any of them, so the argument is that something has to be added.
The standard estimate begins with the sovereign default spread and is often scaled up by the ratio of local equity market volatility to local bond market volatility, on the reasoning that equities in a country are riskier than that country's bonds. Some practitioners then scale the result by the share of revenue a company actually earns in the country, so that an exporter selling into the euro area is not charged as if it were a domestic retailer.
It is genuinely contested, and being able to say so is worth more in an interview than applying it silently. CAPM prices only non diversifiable risk, and an investor holding a global portfolio has diversified a good deal of single country risk already. A flat premium also compounds through the discount factor, so it charges year ten roughly twice as hard as year five, when the underlying risk is normally a discrete event.
The alternative that usually sounds strongest is to put the risk in the cash flows: name the event, give it a probability, model its effect, and present the expected value alongside the scenarios. Whichever route you take, the discipline is to charge for the risk exactly once. Adding a country risk premium on top of a local currency yield that already contains a sovereign default spread is the commonest way of charging twice.
Worked example
Illustratively, five years of 100 discounted at 8.0% is worth 399.3. Add three points of country risk premium and the same stream is worth 369.6.
Express the same view in the cash flows instead: a 20% chance that from year 3 the cash flow falls to a third of plan gives expected cash flows of 100, 100, 86.7, 86.7 and 86.7, worth 369.8 at the original 8.0%.
Same answer, different conversation. Nobody can argue with three points, but anybody can argue about whether the probability is 20% or 5%, and that argument is the analysis.