While a stock’s beta captures country risk in developed markets, in case of developing markets, a country risk spread is added to the market risk premium to account for the country risk.

The simplest yet crudest measure of country risk is sovereign yield spread, which equals the difference between the yield on government bonds of the developing country denominated in a developed market currency and the yield on government bonds in the developed market. A more refined method adjusts sovereign yield spread for the relationship between equity market volatility and debt market volatility of the developing country:

\[ Country\ Equity\ Premium=Sovereign\ Yield\ Spread\times\frac{\sigma_E}{\sigma_B} \]

Where σE is the annualized standard deviation of equity index and σB is the annualized standard deviation of bond market returns in the developed market currency.

For countries that do not have equity markets, country risk analysis can be carried out using credit ratings.

Test

King’s Landing is a developed country and Lannisport is a developing country. You are interested in finding the country risk premium for Lannisport. The following information is available:

Yield on Lannisport government debt ( in Lannisport currency)9.50%
Yield on Lannisport government debt ( in King’s Landing currency)6.50%
Yield on King’s Landing government debt (in King Landing’s currency)4.30%
Standard deviation of Lannisport equity index15.20%
Standard deviation of Lannisport debt market (in Lannisport currency)8.50%
Standard deviation of Lannisport debt market (in King’s Landing currency)4.50%

The country risk premium for Lannisport would be:

  1. 7.43%
  2. 9.30%
  3. 17.56%
Show answer.

A is correct. Sovereign yield spread equals yield on developing country government debt (in developed market currency) minus developed market debt. In this case it equals 2.20% (=6.50% – 4.30%). Next, we need to determine country risk premium by multiplying the sovereign yield spread by the ratio of the standard deviation of equity index by the standard deviation of the developing country bond market in developed market currency:

$$ CRP=(6.50\%\ -\ 4.30\%)\times\frac{15.20\%}{4.50\%}=7.43\% $$

 

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