Country Risk Premium (CRP): What It Is and How To Calculate It

Incorporating CRP into the CAPM

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 risky securities, generating subsequent expected returns for assets, and calculating capital costs.

CAPM Function:

$\begin{aligned} &\text{r}_\text{a} = \text{r}_\text{f} + \beta_\text{a} ( \text{r}_\text{m} – \text{r}_\text{f} ) \\ &\textbf{where:} \\ &\text{r}_\text{f} = \text{risk-free rate of return} \\ &\beta_\text{a} = \text{beta of the security} \\ &\text{r}_\text{m} = \text{expected market return} \\ \end{aligned}$​ra​=rf​+βa​(rm​−rf​)where:rf​=risk-free rate of returnβa​=beta of the securityrm​=expected market return​

There are three approaches for incorporating a Country Risk Premium into the CAPM so as to derive an Equity Risk Premium that can be used to assess the risk of investing in a company located in a foreign country.

The first approach assumes that every company in the foreign country is equally exposed to country risk. While this approach is commonly used, it makes no distinction between any two companies in the foreign country, even if one is a huge export-oriented firm and the other is a small local business. In such cases, CRP would be added to the mature market expected return so that CAPM would be:

$\begin{aligned} &\text{R}_\text{e} = \text{R}_\text{f} + \beta ( \text{R}_\text{m} – \text{R}_\text{f} ) + \text{CRP} \\ \end{aligned}$​Re​=Rf​+β(Rm​−Rf​)+CRP​

The second approach assumes that a company’s exposure to country risk is similar to its exposure to other market risk. Thus,

$\begin{aligned} &\text{R}_\text{e} = \text{R}_\text{f} + \beta ( \text{R}_\text{m} – \text{R}_\text{f} + \text{CRP} ) \\ \end{aligned}$​Re​=Rf​+β(Rm​−Rf​+CRP)​

The third approach considers country risk as a separate risk factor, multiplying CRP with a variable (generally denoted by lambda or λ). In general terms, a company that has significant exposure to a foreign country—by virtue of getting a large percentage of its revenues from that country or having a substantial share of its manufacturing located there—would have a higher λ value than a company that is less exposed to that country.

Example

If a company considering setting up a project in Country A had the following parameters, its cost of equity calculation would look like:

$\begin{aligned} &\text{CRP for Country A} = 7.0\% \\ &\text{R}_\text{f} = \text{risk-free rate} = 2.5\% \\ &\text{R}_\text{m} = \text{expected market return} = 7.5\% \\ &\text{Project Beta} = 1.25 \\ &\text{Cost of equity} = \text{R}_\text{f} + \beta ( \text{R}_\text{m} – \text{R}_\text{f} + \text{CRP} ) \\ &\phantom{\text{Cost of equity}} = 2.5\% + 1.25 \ ( 7.5\% – 2.5\% + 7.0 )\\ &\phantom{\text{Cost of equity}} = 17.5\% \end{aligned}$​CRP for Country A=7.0%Rf​=risk-free rate=2.5%Rm​=expected market return=7.5%Project Beta=1.25Cost of equity=Rf​+β(Rm​−Rf​+CRP)Cost of equity=2.5%+1.25 (7.5%−2.5%+7.0)Cost of equity=17.5%​

Pros and Cons of Country Risk Premium

While most would agree that country risk premia help by representing that a country, such as Myanmar, would present more uncertainty than Germany, for instance, some opponents question the utility of CRP. Some suggest that country risk is diversifiable. With regard to the CAPM 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 can 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 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 and/or economic instability, would be worked into expected cash flows, therefore eliminating the need for adjustments elsewhere in the calculation.

Special Considerations

BlackRock, the world’s largest asset manager, has a «Geopolitical Risk Dashboard» that analyzes leading risks. As of Jul 2023, these risks included:

• U.S.-China Relations
• Russia-NATO Conflict
• Major Cyberattacks
• Gulf Tensions
• Major Terror Attacks
• Emerging Markets Political Crisis
• North Korea Conflict
• Climate Policy Gridlock
• European Fragmentation

While some of these issues may be resolved in time, it would seem prudent to account for these risk factors in evaluating returns from a project or investment located in a foreign country.

The Bottom Line

Overall, the CRP serves a useful purpose by quantifying the higher return expectations for investments in foreign jurisdictions, which undoubtedly have an additional layer of risk compared with domestic investments. As of 2023, the risks of overseas investing appear to be somewhat constant, given trade tensions and other global concerns.