Country Risk Premium Adjustment Example
Let’s say you want to invest in a project in Venezuela and you are working on valuation of the project. You also know that if you want to finance this project through equity, you need calculate its cost through CAPM. Even tough capital asset pricing model works perfectly for US companies, it does not capture the country risk premium for the projects abroad. So how should you adjust that?
First you should compile the information about:
1-Venezuelan US dollar denominated 10 year government bond yield
2-10 year US Treasury bond yield
3- Annualized Std. Deviation of Venezuelan stock index
4. Annualized Std. Deviation of Venezuelan US Dollar denominated 10 year government bond
So the spread between bond yields are= Venezuelan US dollar denominated 10 year government bond yield- 10 year US Treasury bond yield
and the country risk premium is = bond yield spread * (Std. Deviation of Stock Index of Venezuela/ Std. Deviation of Venezuelan US denominated 10 year government bond)
how will you adjust the capm?
cost of equity = risk free rate + Beta [ Market Risk Premium + Country Risk Premium]
that is how you should adjust for the country risk.