In developed nations, the beta of a stock adequately captures the country risk (Historical evidence). However, this doesn’t hold true for developing nations. Therefore, the calculation of cost of equity using CAPM requires adding a country risk spread to the market risk premium. This is also called the country equity premium.

The Country Risk Premium can be calculated using the following methods:

Method 1

The first method is to use the Sovereign Yield Spread as the country spread.

Sovereign Yield Spread = Country’s Government Bond Yield – Treasury Bond Yield in a Developed Country

This method is considered too rough and is not generally used.

Method 2

The second method is more robust and calculates the country equity premium as follows:

$Country\ Equity\ Premium = Country\ Default\ Spread \frac{\sigma_{Equity} }{\sigma_{Country\ Bond}}$

As we can see, this method takes the Country Default Spread (Sovereign yield spread) as a measure of the general country risk and then adjusts it for the volatility of stock market relative to the bond market.

The country default spread can also be observed using the country ratings.

Assume that HighRisk Country was rated BB by a rating agency, which resulted in a default spread of 3%. The annualized standard deviation of the country’s equity index is 30%, and the annualized standard deviation for their bond market is 10%.

The country equity risk premium will be calculated as follows:

HighRisk Country’s risk premium = 3% * (30%/10%)= 9%

If the credit rating of the country drops further, or if the equity market becomes more volatile, the equity risk premium will increase. The estimate is also affected by the time horizon used for calculating the premium.

Note: This approach was suggested by Aswath Damodaran in his paper "Estimating Equity Risk Premiums".