Risk Premium for a Mature Market?

Broadening
the sample to 1900-2017
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 The simplest way of estimating an additional
country risk premium: The country default spread
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¨ Default spread for country: In this approach, the country equity risk
premium is set equal to the default spread for the country,
estimated in one of three ways:
¤ The default spread on a dollar denominated bond issued by the country.
(In January 2020, that spread was % for the Brazilian $ bond) was 1.71%.
¤ The sovereign CDS spread for the country. In January 2020, the ten-year
CDS spread for Brazil, adjusted for the US CDS, was 1.56%.
¤ The default spread based on the local currency rating for the country.
Brazil’s sovereign local currency rating is Ba2 and the default spread for a
Ba2 rated sovereign was about 2.51% in January 2020.
¨ Add the default spread to a “mature” market premium: This default
spread is added on to the mature market premium to arrive at the
total equity risk premium for Brazil, assuming a mature market
premium of 5.20%.
¤ Country Risk Premium for Brazil = 2.51%
¤ Total ERP for Brazil = 5.20% + 2.51% = 7.71%

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 An equity volatility based approach to
estimating the country total ERP
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¨ This approach draws on the standard deviation of two equity

markets, the emerging market in question and a base market
(usually the US). The total equity risk premium for the
emerging market is then written as:
¤ Total equity risk premium = Risk PremiumUS* sCountry Equity / sUS Equity
¨ The country equity risk premium is based upon the volatility
of the market in question relative to U.S market.
¤ Assume that the equity risk premium for the US is 5.20%.
¤ Assume that the standard deviation in the Bovespa (Brazilian equity) is
30% and that the standard deviation for the S&P 500 (US equity) is
18%.
¤ Total Equity Risk Premium for Brazil = 5.20% (30%/18%) = 8.67%
¤ Country equity risk premium for Brazil = 8.67% - 5.20% = 3.47%

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 A melded approach to estimating the additional
country risk premium
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¨ Country ratings measure default risk. While default risk premiums

and equity risk premiums are highly correlated, one would expect
equity spreads to be higher than debt spreads.
¨ Another is to multiply the bond default spread by the relative
volatility of stock and bond prices in that market. Using this
approach for Brazil in January 2020, you would get:
¤ Country Equity risk premium = Default spread on country bond* sCountry
Equity / sCountry Bond
n Standard Deviation in Bovespa (Equity) = 30%
n Standard Deviation in Brazil government bond = 20%
n Default spread for Brazil= 2.51%
¤ Brazil Country Risk Premium = 2.51% (30%/20%) = 3.77%
¤ Brazil Total ERP = Mature Market Premium + CRP = 5.20% + 3.77% = 8.97%

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A Template for Estimating the ERP

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ERP : Jan 2020

Aswath Damodaran Black #: Total ERP

Red #: Country risk premium
AVG: GDP weighted average
 From Country Equity Risk Premiums to
Corporate Equity Risk premiums
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¨ Approach 1: Assume that every company in the country is

equally exposed to country risk. In this case,
¤ E(Return) = Riskfree Rate + CRP + Beta (Mature ERP)
¨ Approach 2: Assume that a company’s exposure to country
risk is similar to its exposure to other market risk.
¤ E(Return) = Riskfree Rate + Beta (Mature ERP+ CRP)
¨ Approach 3: Treat country risk as a separate risk factor and
allow firms to have different exposures to country risk
(perhaps based upon the proportion of their revenues come
from non-domestic sales)
¤ E(Return)=Riskfree Rate+ (Mature ERP) + l (CRP)
Mature ERP = Mature market Equity Risk Premium
CRP = Additional country risk premium

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 Approaches 1 & 2: Estimating country risk
premium exposure
55

¨ Location based CRP: The standard approach in valuation is to

attach a country risk premium to a company based upon its
country of incorporation. Thus, if you are an Indian company,
you are assumed to be exposed to the Indian country risk
premium. A developed market company is assumed to be
unexposed to emerging market risk.
¨ Operation-based CRP: There is a more reasonable modified
version. The country risk premium for a company can be
computed as a weighted average of the country risk
premiums of the countries that it does business in, with the
weights based upon revenues or operating income. If a
company is exposed to risk in dozens of countries, you can
take a weighted average of the risk premiums by region.
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 Operation based CRP: Single versus Multiple
Emerging Markets
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¨ Single emerging market: Embraer, in 2004, reported that it derived 3% of

its revenues in Brazil and the balance from mature markets. The mature
market ERP in 2004 was 5% and Brazil’s CRP was 7.89%.

¨ Multiple emerging markets: Ambev, the Brazilian-based beverage

company, reported revenues from the following countries during 2011.

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 Extending to a multinational: Regional breakdown
Coca Cola’s revenue breakdown and ERP in 2012
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Things to watch out for

1. Aggregation across regions. For instance, the Pacific region often includes Australia & NZ with Asia
2. Obscure aggregations including Eurasia and Oceania
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 Two problems with these approaches..
58

¨ Focus just on revenues: To the extent that revenues are

the only variable that you consider, when weighting risk
exposure across markets, you may be missing other
exposures to country risk. For instance, an emerging
market company that gets the bulk of its revenues
outside the country (in a developed market) may still
have all of its production facilities in the emerging
market.
¨ Exposure not adjusted or based upon beta: To the extent
that the country risk premium is multiplied by a beta, we
are assuming that beta in addition to measuring
exposure to all other macro economic risk also measures
exposure to country risk.

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 A Production-based ERP: Royal Dutch Shell
in 2015
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Country Oil & Gas Production % of Total ERP

Denmark 17396 3.83% 6.20%
Italy 11179 2.46% 9.14%
Norway 14337 3.16% 6.20%
UK 20762 4.57% 6.81%
Rest of Europe 874 0.19% 7.40%
Brunei 823 0.18% 9.04%
Iraq 20009 4.40% 11.37%
Malaysia 22980 5.06% 8.05%
Oman 78404 17.26% 7.29%
Russia 22016 4.85% 10.06%
Rest of Asia & ME 24480 5.39% 7.74%
Oceania 7858 1.73% 6.20%
Gabon 12472 2.75% 11.76%
Nigeria 67832 14.93% 11.76%
Rest of Africa 6159 1.36% 12.17%
USA 104263 22.95% 6.20%
Canada 8599 1.89% 6.20%
Brazil 13307 2.93% 9.60%
Rest of Latin America 576 0.13% 10.78%
Royal Dutch Shell 454326 100.00% 8.26%

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 Approach 3: Estimate a lambda for country risk
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¨ Country risk exposure is affected by where you get your

revenues and where your production happens, but there are
a host of other variables that also affect this exposure,
including:
¤ Use of risk management products: Companies can use both options/futures
markets and insurance to hedge some or a significant portion of country risk.
¤ Government “national” interests: There are sectors that are viewed as vital to
the national interests, and governments often play a key role in these
companies, either officially or unofficially. These sectors are more exposed to
country risk.
¨ It is conceivable that there is a richer measure of country risk
that incorporates all of the variables that drive country risk in
one measure. That way my rationale when I devised
“lambda” as my measure of country risk exposure.

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A Revenue-based Lambda

¨ The factor “l” measures the relative exposure of a firm to country

risk. One simplistic solution would be to do the following:
l = % of revenues domesticallyfirm/ % of revenues domesticallyaverage firm
¨ Consider two firms – Tata Motors and Tata Consulting Services,
both Indian companies. In 2008-09, Tata Motors got about 91.37%
of its revenues in India and TCS got 7.62%. The average Indian firm
gets about 80% of its revenues in India:
l Tata Motors= 91%/80% = 1.14
l TCS= 7.62%/80% = 0.09
¨ There are two implications
¤ A company’s risk exposure is determined by where it does business and
not by where it is incorporated.
¤ Firms might be able to actively manage their country risk exposures

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 A Price/Return based Lambda
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ReturnEmbraer = 0.0195 + 0.2681 ReturnC Bond

ReturnEmbratel = -0.0308 + 2.0030 ReturnC Bond
Embraer versus C Bond: 2000-2003 Embratel versus C Bond: 2000-2003
40 100

80

20
60

40

Return on Embrat el
Return on Embraer

0
20

0
-20
-20

-40 -40

-60

-60 -80
-30 -20 -10 0 10 20 -30 -20 -10 0 10 20

Return on C-Bond Return on C-Bond

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 Estimating a US Dollar Cost of Equity for
Embraer - September 2004
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¨ Assume that the beta for Embraer is 1.07, and that the US $ riskfree rate
used is 4%. Also assume that the risk premium for the US is 5% and the
country risk premium for Brazil is 7.89%. Finally, assume that Embraer
gets 3% of its revenues in Brazil & the rest in the US.
¨ There are five estimates of $ cost of equity for Embraer:
¤ Approach 1: Constant exposure to CRP, Location CRP
n E(Return) = 4% + 1.07 (5%) + 7.89% = 17.24%
¤ Approach 2: Constant exposure to CRP, Operation CRP
n E(Return) = 4% + 1.07 (5%) + (0.03*7.89% +0.97*0%)= 9.59%
¤ Approach 3: Beta exposure to CRP, Location CRP
n E(Return) = 4% + 1.07 (5% + 7.89%)= 17.79%
¤ Approach 4: Beta exposure to CRP, Operation CRP
n E(Return) = 4% + 1.07 (5% +( 0.03*7.89%+0.97*0%)) = 9.60%
¤ Approach 5: Lambda exposure to CRP
n E(Return) = 4% + 1.07 (5%) + 0.27(7.89%) = 11.48%

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 Valuing Emerging Market Companies with
significant exposure in developed markets
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¨ The conventional practice in investment banking is to add the

country equity risk premium on to the cost of equity for every
emerging market company, notwithstanding its exposure to
emerging market risk. Thus, in 2004, Embraer would have
been valued with a cost of equity of 17-18% even though it
gets only 3% of its revenues in Brazil. As an investor, which of
the following consequences do you see from this approach?
a. Emerging market companies with substantial exposure in developed
markets will be significantly over valued by analysts
b. Emerging market companies with substantial exposure in developed
markets will be significantly under valued by analysts
Can you construct an investment strategy to take advantage of the
mis-valuation? What would need to happen for you to make money
of this strategy?

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 Implied Equity Premiums
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¨ For a start: If you know the price paid for an asset and have
estimates of the expected cash flows on the asset, you can
estimate the IRR of these cash flows. If you paid the price,
this is your expected return.
¨ Stock Price & Risk: If you assume that stocks are correctly
priced in the aggregate and you can estimate the expected
cashflows from buying stocks, you can estimate the expected
rate of return on stocks by finding that discount rate that
makes the present value equal to the price paid.
¨ Implied ERP: Subtracting out the riskfree rate should yield an
implied equity risk premium. This implied equity premium is
a forward-looking number and can be updated as often as
you want (every minute of every day, if you are so inclined).

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 Implied Equity Premiums: January 2008
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¨ We can use the information in stock prices to back out how risk averse the market is and how much of a risk
premium it is demanding.
After year 5, we will assume that
Between 2001 and 2007 Analysts expect earnings to grow 5% a year for the next 5 years. We earnings on the index will grow at
4.02%, the same rate as the entire
dividends and stock will assume that dividends & buybacks will keep pace.. economy (= riskfree rate).
buybacks averaged 4.02% Last year’s cashflow (59.03) growing at 5% a year
of the index each year.
61.98 65.08 68.33 71.75 75.34

January 1, 2008
S&P 500 is at 1468.36
4.02% of 1468.36 = 59.03

¨ If you pay the current level of the index, you can expect to make a return of 8.39% on stocks (which is obtained by
solving for r in the following equation)
61.98 65.08 68.33 71.75 75.34 75.35(1.0402)
1468.36 = + + + + +
(1+ r) (1+ r) 2 (1+ r) 3 (1+ r) 4 (1+ r) 5 (r − .0402)(1+ r) 5
¨ Implied Equity risk premium = Expected return on stocks - Treasury bond rate = 8.39% - 4.02% = 4.37%

€
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 A year that made a difference.. The implied
premium in January 2009
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Year Market value of index Dividends Buybacks Cash to equity Dividend yield Buyback yield Total yield
2001 1148.09 15.74 14.34 30.08 1.37% 1.25% 2.62%
2002 879.82 15.96 13.87 29.83 1.81% 1.58% 3.39%
2003 1111.91 17.88 13.70 31.58 1.61% 1.23% 2.84%
2004 1211.92 19.01 21.59 40.60 1.57% 1.78% 3.35%
2005 1248.29 22.34 38.82 61.17 1.79% 3.11% 4.90%
2006 1418.30 25.04 48.12 73.16 1.77% 3.39% 5.16%
2007 1468.36 28.14 67.22 95.36 1.92% 4.58% 6.49%
2008 903.25 28.47 40.25 68.72 3.15% 4.61% 7.77%
Normalized 903.25 28.47 24.11 52.584 3.15% 2.67% 5.82%

In 2008, the actual cash

returned to stockholders was After year 5, we will assume that
68.72. However, there was a earnings on the index will grow at
41% dropoff in buybacks in Analysts expect earnings to grow 4% a year for the next 5 years. We
will assume that dividends & buybacks will keep pace.. 2.21%, the same rate as the entire
Q4. We reduced the total economy (= riskfree rate).
buybacks for the year by that Last year’s cashflow (52.58) growing at 4% a year
amount. 54.69 56.87 59.15 61.52 63.98

54.69 56.87 59.15 61.52 63.98 63.98(1.0221)

January 1, 2009 903.25 = + + + + +
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r −.0221)(1+ r)5
2 3 4 5

S&P 500 is at 903.25

Adjusted Dividends & Expected Return on Stocks (1/1/09) = 8.64%
Buybacks for 2008 = 52.58 Riskfree rate = 2.21%
Equity Risk Premium = 6.43%
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 The Anatomy of a Crisis: Implied ERP from
September 12, 2008 to January 1, 2009
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 An Updated Equity Risk Premium: January
2020
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Implied Premiums in the US: 1960-2019

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 Implied Premium versus Risk Free Rate
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 Equity Risk Premiums and Bond Default Spreads
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Equity Risk Premiums and Bond Default Spreads

7.00% 9.00
Median ERP/ Baa Spread during period = 1.96
8.00
6.00%
7.00
5.00%
Premium (Spread)

6.00

ERP / Baa Spread

4.00% 5.00

3.00% 4.00

3.00
2.00%
2.00
1.00%
1.00

0.00% 0.00
1960
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
ERP/Baa Spread Baa - [Link] Rate ERP

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 Equity Risk Premiums and Cap Rates (Real
Estate)
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Figure 18: Equity Risk Premiums, Cap Rates and Bond Spreads
8.00%

6.00%

4.00%

2.00%

ERP
0.00% Baa Spread
1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

2016

2018
Cap Rate premium

-2.00%

-4.00%

-6.00%

-8.00%

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 Why implied premiums matter?
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¨ In many investment banks, it is common practice (especially

in corporate finance departments) to use historical risk
premiums (and arithmetic averages at that) as risk premiums
to compute cost of equity. If all analysts in the department
used the arithmetic average premium (for stocks over [Link])
for 1928-2019 of 8.18% to value stocks in January 2019, given
the implied premium of 5.20%, what are they likely to find?
a. The values they obtain will be too low (most stocks will look
overvalued)
b. The values they obtain will be too high (most stocks will look under
valued)
c. There should be no systematic bias as long as they use the same
premium to value all stocks.
¨ What if analysts are using the historical geometric average
premium of 4.83% from 1928 to 2019 as their ERP?

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