How to Calculate Country Risk Premium

When you deal in uncertain securities, you must consider the risk of losing your investment. If you invest in other countries, particularly developing markets, this risk is especially high. A nation's poor governance, economic instability, or simply an uneven track record, can deter investors, so its securities must promise especially high returns. The country risk premium describes the extent of this difference. Economies on the same level as the United States have no risk premium. Developing nations, or those suffering economic instability, have higher premiums; Greece's recent debt crisis, for instance, left it a risk premium of 16.5 percent.

Step 1

Add 1 to the country's inflation rate and to your own country's inflation rate. For example, if the country has an inflation rate of 6 percent while yours has one of 2 percent, add 1 to 0.06 and 0.02 to get 1.06 and 1.02.

Step 2

Divide the first of these figures by the second. Continuing the example, divide 1.06 by 1.02 to get 1.039.

Step 3

Add 1 to the risk-free interest rate, which you can often estimate as the U.S. Treasury bond rate. For example, if the risk-free interest rate is 2.1 percent, add 1 to 0.021 to get 1.021.

Step 4

Multiply this figure by the earlier ratio. Continuing the example, multiply 1.021 by 1.039 to get 1.061.

Step 5

Subtract 1 to estimate the country's risk-free interest rate. Continuing the example, subtract 1 from 1.061 to get 0.061, or 6.1 percent.

Step 6

Add together the average dividend yield in the country's stock market and the expected average earnings growth rate. For example, if the country's stock market currently yields 7 percent annually and earnings are expected to grow by 4.5 percent each year, add 7 and 4.5 to get 11.5 percent. This is the expected return on a diversified portfolio in the country.

Step 7

Subtract the country's risk-free interest rate from the expected return of a diversified portfolio. Continuing the example, subtract 6.1 from 11.5 to get 5.4. This is the country's risk premium.

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