Explained: Country risk premium

What is a country risk premium? 

Any additional risk in the underlying asset is expected to be rewarded accordingly by any risk-averse investor. A risk premium is the additional expected return from an investment for bearing risk. The risk premium demanded to compensate the higher risk of investing in a foreign country, is called country risk premium or CRP.      

Why is country risk premium important? 

In India, investing in a foreign country’s equity market has become easier over time even for retail investors. But as you invest in a new nation, come additional risks. The political environment, currency fluctuations, economic stability, legal restrictions, sovereign debt levels, etc are a few of the many factors that may add risk levels to your investments. And understanding the risk profile i.e. the CRP becomes crucial before making an investment decision as it can have a significant impact on the valuation of equity. 

The basic idea behind CRP is that the developing nations bear higher CRP than developed nations, since investing in developing countries is riskier. For example, according to analysts, CRP for a developing nation like India is estimated at 2.13 per cent while for a developed nation like the UK it is just 0.59 per cent. For the US, Singapore, Sweden, Germany it is nearly zero. 

How to calculate and make use of CRP?  

There are two methods to calculate CRP: 

CRP for a country (A)= Spread on country A’s sovereign debt yield x (annualized standard deviation of country A’s equity index / annualized standard deviation of country A’s sovereign bond index) 

It can be calculated by comparing the sovereign debt yield of country A with that of a developed nation like the US. 

However, one can find it by reading through papers by famous analysts like Aswath Damodaran. Once you find the CRP, you need to add it to the equity risk premium. What it ultimately will tell you is, how much of minimum you should expect to earn from the investment.