The premium is easy to estimate and easy to misapply. Whether it goes in full, through beta or through lambda, and whether the risk-free rate already carries it, moves the value by a fifth either way.
Estimate the country risk premium as the sovereign default spread scaled up by the ratio of equity to bond volatility, then decide how much of it the company is exposed to. With an illustrative 3.0 per cent spread and a ratio of 1.50, the premium is 4.50 per cent, which lifts a 9.75 per cent US dollar cost of equity to 14.25 per cent and cuts the DCF value from 209.4 to 123.9. How it enters the rate moves the value from 118.9 to 148.3, and a common double count takes it to 97.0, so the method is a valuation judgement in its own right.
Worked in full in The Private Markets Valuation Specialist by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
For a fund holding a company in an emerging or frontier market, the country risk premium is often the largest single judgement in the income approach: larger than the beta, the size premium or the terminal growth rate. It is also one of the easiest to get wrong in a way that looks reasonable.
| Input | Value |
|---|---|
| US dollar risk-free rate | 4.25% |
| Mature market equity risk premium | 5.0% |
| Beta | 1.1 |
| Sovereign default spread (dollar bond over the US rate) | 3.0% |
| Volatility of the country's equity index | 27.0% |
| Volatility of the sovereign dollar bond | 18.0% |
| Company's exposure to the country (lambda) | 0.6 |
| Free cash flow, year 1, growing 8% a year to year 5 | 12.0 |
| Terminal growth | 3.0% |
Relative volatility: 27.0% ÷ 18.0% = 1.50. Equities in the country are half as volatile again as its government bonds.
Country risk premium = default spread × relative volatility = 3.0% × 1.50 = 4.50%.
Base cost of equity without it: 4.25% + 1.1 × 5.0% = 9.75%.
In Excel, with the spread in B1, the two volatilities in B2 and B3 and the base rate in B4: =B4+B1*B2/B3.
The default spread alone measures what bondholders demand for sovereign default risk. Scaling it by relative volatility converts it into an equity premium, on the reasoning that equity in the same market is riskier than its debt. This is the approach popularised by Aswath Damodaran; practice varies, and some valuers use the default spread alone or derive it from the sovereign rating or credit default swaps rather than from bond yields.
| Method | Discount rate | PV of years 1 to 5 | PV of terminal value | Value | Versus added in full |
|---|---|---|---|---|---|
| No country risk | 9.75% | 53.0 | 156.5 | 209.4 | 69.1% |
| Added in full: 9.75% + 4.50% | 14.25% | 47.1 | 76.8 | 123.9 | 0.0% |
| Scaled by beta: 4.25% + 1.1 × (5.0% + 4.50%) | 14.70% | 46.5 | 72.4 | 118.9 | −4.0% |
| Lambda: 9.75% + 0.6 × 4.50% | 12.45% | 49.3 | 99.0 | 148.3 | 19.7% |
| Double counted (see below) | 17.25% | 43.7 | 53.3 | 97.0 | −21.7% |
Adding the premium in full cuts the value by 40.9 per cent against ignoring it. Most of that comes from the terminal value, which falls from 156.5 to 76.8, because the premium applies to every year in perpetuity.
| Default spread | Country risk premium | Rate, added in full | Value | Rate, lambda 0.6 | Value |
|---|---|---|---|---|---|
| 1.0% | 1.50% | 11.25% | 170.5 | 10.65% | 184.2 |
| 2.0% | 3.00% | 12.75% | 143.6 | 11.55% | 164.3 |
| 3.0% | 4.50% | 14.25% | 123.9 | 12.45% | 148.3 |
| 4.0% | 6.00% | 15.75% | 108.8 | 13.35% | 135.0 |
| 6.0% | 9.00% | 18.75% | 87.4 | 15.15% | 114.4 |
Each one-point rise in the sovereign spread cuts the value by 12 to 16 per cent here when the premium is added in full. Sovereign spreads can move that much in a quarter, which is why a mark that refreshes the beta and the multiples but leaves the country premium at its acquisition level is not consistent with the measurement date.
The double-counted row comes from a common shortcut. The analyst uses the country's own dollar government bond yield, 7.25 per cent, as the risk-free rate because it is "the local risk-free rate", then adds the full 4.50 per cent premium on top. The 7.25 per cent already contains the 3.0 per cent default spread, so country risk is charged once in the risk-free rate and again in the premium. The rate becomes 17.25 per cent and the value 97.0, 21.7 per cent below the method it was meant to apply.
The rule is to choose one place for country risk. Either start from the US dollar risk-free rate and add the full premium, or start from the 7.25 per cent local dollar bond yield and add only the part of the premium above the default spread, 1.50 points here, which gives the same 14.25 per cent. Do not do both. The same discipline applies to currency: dollar cash flows need a dollar rate, and local-currency cash flows need a local rate that carries the inflation differential.
Fair value check: whichever method is chosen, run it at the acquisition date. If the rate it produces does not reproduce the price paid, the difference is a calibration adjustment to carry forward, as set out in calibrating a DCF discount rate to the transaction price, not a reason to switch methods quarter to quarter.
Country risk premium = default spread × equity-to-bond volatility, 4.50 per cent here; then apply it in full, through beta, or through lambda, and document why. On these figures the choice is worth 123.9 against 148.3, and double counting the spread takes the value to 97.0. The income approach worksheets in the free workbook for this case show how much of a DCF sits in the terminal value, which is where the premium does most of its work.
Take the country's sovereign default spread, from its dollar bonds over US Treasuries or from credit default swaps, and multiply by the ratio of the volatility of its equity market to that of its sovereign bonds. In the illustrative case 3.0 per cent times 27.0 divided by 18.0, a ratio of 1.50, gives a premium of 4.50 per cent.
It is one of three accepted methods. Adding the premium in full gives an illustrative rate of 14.25 per cent; scaling it by a beta of 1.1 gives 14.70 per cent; scaling it by a lambda of 0.6 for the company's own exposure gives 12.45 per cent. The values are 123.9, 118.9 and 148.3, so the method should be chosen and documented, not defaulted.
Only if you then do not add a premium for the same default risk. A local dollar bond yield of 7.25 per cent already includes a 3.0 per cent default spread; adding a 4.50 per cent premium on top counts it twice, giving a 17.25 per cent rate and an illustrative value of 97.0, 21.7 per cent too low.
This article is one calculation from The Private Markets Valuation Specialist. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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