How to Adjust Country Risk Premium in CAPM?
If you are valuing a project taking place in a developing country, the Capital Asset Pricing Formula, the rate of return for common equity, is a bit problematic because Beta does not adequately capture country risk. To reflect the increased risk associated with investing in a developing country, a country riks premium is added to the market risk premium when using the CAPM.
The risk of the developing country is reflected in its sovereign yield spread. This is the difference in yields between the developing country’s government bonds and Treasury bonds of a similar maturity. To estimate an equity risk premium for the country, adjust the sovereign yield spread by the ratio of volatility between the country’s equity market and its government bond market. A more equity market increases the country risk premium, other things equal.
So revised CAPM equation is
Return on common equity = Risk Free Rate + Beta [Expected Return on Market- Risk Free Rate +Country Risk Premium]
where CRP is the country risk premium.
CRP = sovereign yield spread x [annualized standard deviation of equity index of developing country/annualized standard deviation of Treasury ]
Below is the link for an example: