What is a Country Risk Premium (CRP)
Country risk premium (CRP) is the additional risk associated with investing in an international company, rather than the domestic market. Macroeconomic factors, such as political instability, volatile exchange rates, and political turmoil can all cause investors to be wary of overseas investment opportunities. For these reasons, many such international opportunities require a premium for investing. The country risk premium (CRP) is higher for developing markets than for developed nations.
BREAKING DOWN Country Risk Premium (CRP)
Country Risk Premia can have a significant impact on a myriad of valuable calculations, including corporate valuation and corporate finance more broadly. CRP should be critical when considering investing in foreign markets and/or multinational corporations.
Total calculations of equity risk premia for countries often begin with with a mature market risk premium. The mature market risk premium is derived from the implied equity risk premium for the S&P 500. To this can be added the additional specific CRP, based on the country’s default spread. As expected, a more volatile country, such as Venezuela, will have a higher CRP than that of a more stable nation, such as the United States.
The Capital Asset Pricing Model (CAPM) can be adjusted to reflect the additional risks of international investing. The CAPM details the relationship between systematic risk and expected return for assets, particularly stocks. The CAPM model is widely used throughout the financial services industry for the purposes of pricing of risky securities, generating subsequent expected returns for assets, and calculating capital costs.
CAPM function, adjusted for CRP:
Re = Rf + β(Rm – Rf + CRP)
Arguments Against Using the Country Risk Premium
While most would agree that country risk premiums help by representing that a country, such as Myanmar, would present more uncertainty than, say, Germany; many also argue against the variable altogether. Some suggest that country risk is diversifiable. With regards to the capital asset pricing model, described above, along with other risk and return models – which entail non-diversifiable market risk – the question remains as to whether additional emerging market risk is able to be diversified away. In this case, some argue no additional premia should be charged.
Others believe the traditional CAPM can be broadened into a global model, thus incorporating various CRPs. In this view, a global CAPM would capture a single global equity risk premium, relying on an asset’s beta to determine volatility. A final major argument rests on the belief that country risk is better reflected in a company’s cash flows than the utilized discount rate. Adjustments for possible negative events within a nation, such as political drama and/or economic instability, would be worked into expected cash flows, therefore eliminating the need for adjustments elsewhere in the calculation.