Equity Risk Premium (ERP)

S&P U.S. Equity Risk Premium Index (Historical Chart)

^{10-Year Historical U.S. Equity Risk Premium (Source: S&P Global)}

How Does the Country Risk Premium (CRP) Work?

When calculating the cost of equity under the CAPM approach, one common adjustment is called the country risk premium (CRP), which encompasses the same factors as listed in the previous section.

As one would reasonably expect, political instability, economic risks (e.g. recessions, inflation), default risk, and currency fluctuations impact countries unevenly.

For instance, the issue of hyperinflation in Venezuela, which began in 2016, presents a significant country-specific risk that causes instability in all aspects of the country, whether political, socioeconomic, or financial.

With that said, equities in emerging markets come with higher risks, which means higher potential returns to compensate investors.

Hence, many institutional investment firms nowadays have raised foreign funds to pursue investments outside developed countries.

While part of the reason is diversification, another critical consideration is the limited number of investment opportunities in developed countries that meet their minimum returns hurdle.

Considering that foreign, less developed countries typically have fewer capital providers, outside firms often hold more negotiating leverage – directly leading to more compensation.

Learn More → ERP Determinants, Estimation, and Implications (Damodaran)

Equity Risk Premium Calculator

We’ll now move to a modeling exercise, which you can access by filling out the form below.

Excel Template | File Download Form

First Name *

Email *

Submit

By submitting this form, you consent to receive email from Wall Street Prep and agree to our terms of use and privacy policy.

Email provided

Your Download is Ready

Submitting...

1. Equity Risk Premium Calculation Example

In the first section of our modeling tutorial, we’ll calculate the equity risk premium.

The two required inputs are listed below:

1. Estimated Market Return
2. Risk-Free Rate

Here, we’ll calculate the ERP for two companies, one based in a developed country while the other is in an emerging market.

Developed Country – Company Assumptions

• Risk-Free Rate (rf) = 2.0%
• Expected Market Return (rm) = 7.5%

Emerging Country – Company Assumptions

• Risk-Free Rate (rf) = 6.5%
• Expected Market Return (rm) = 15%

For both companies, we’ll subtract the risk-free rate from the expected market return to get the following figures for our equity risk premium:

Equity Risk Premiums

• Developed Market – Company: 5.5%
• Emerging Market – Company: 8.5%

Countries with economies classified as “emerging” markets are less developed economically, so there’s more room for companies to come in and capture market share, but there are also more risks (and required expenditures).

The 5.5% and 8.5% ERP represents the excess return above the risk-free applicable to the appropriate country.

Note that the correct risk-free rate is for the country the company in question does business in, so using the 10-year Treasury note for a company in Japan is incorrect – as a general rule of thumb, the currencies should match.

As affirmed by our example, equity risk premiums tend to be higher in emerging markets than developed markets.

2. Country Risk Premium (CRP) Adjustment

In the next and final part of our modeling exercise, we’ll see how country-specific risks affect the cost of equity calculation under the CAPM approach.

For the company in a developed market (e.g. U.S.), there is no need for a country risk premium (CRP) adjustment.

However, a CRP adjustment would be appropriate for the company in an emerging market (e.g. Argentina, Brazil, Russia).

Here, we’ll assume the 4.0% CRP adjustment is added to the cost of equity calculation, as shown below.

3. Cost of Equity Calculation Example

From our completed model, the calculated cost of equity is 6.4% and 22.4% in developed and emerging market companies, respectively.

• Cost of Equity (Developed) = 6.4%
• Cost of Equity (Emerging) = 22.4%