By, Prof. Aswath Damodaran - Professor of Finance, New York University
As companies expand operations into emerging markets and investors search for investment opportunities in Asia and Latin America, they are also increasingly exposed to additional risk in these countries.
Globally diversified investors can eliminate some country risk by diversifying across equities in many countries, but the increasing correlation across markets suggests that country risk cannot be entirely diversified away.
Myriad sources contribute to a country’s risk, including where a country is in the economic growth life cycle, the political hierarchy and transition of power in a country, and the structure and efficiency of the legal system in a country. Country risk can also stem from an economy’s disproportionate dependence on a particular product or service.
Several services attempt to measure country risk, though not always from the same perspective or for the same audience. However, these services have limitations. Many of the entities developing the methodology give less consideration to business risks. Additionally, the scores are not standardized and each service uses its own protocol.
The most direct measure of country risk is the default risk when lending to the government of that country—termed sovereign default risk. Measures of sovereign default risk are necessary to not only set interest rates on sovereign bonds and loans but to price all other assets.
While various agencies have their own system for estimating sovereign ratings, the processes share a great deal in common. For instance, agencies typically focus on economic, political, and institutional detail.
When estimating country-specific equity risk premiums, three different approaches can be utilized. The first is to use historical data in each market to estimate an equity risk premium for that market, an approach potentially fraught with statistical and structural problems in most emerging markets.
The second approach is to start with an equity risk premium for a mature market and build up to or estimate additional risk premiums for riskier countries. The third approach is to use the market pricing of equities within each market to back out estimates of an implied equity risk premium for the market.
If country risk demands a premium, the next question to analyze relates to the exposure of individual companies to that risk. Three broad approaches exist for addressing this question.
The first and simplest is to base the country risk assessment on where the company is incorporated.
The second, arguably more sensible approach, is to base the country risk exposure on where a company operates rather than where it is incorporated.
The third approach requires estimating a relative measure of company exposure to country risk, akin to a beta.