Damodaran’s Country Risk Premium
|1 |Introduction |2 | | | | | |2 |CRP concept |2 | | | | | |3 |Critique of the CRP concept |7 | | | | |
For several years, when setting discount rates Damodaran has advocated more consideration of country risk premiums (CRP ) when it comes to assessing com- panies with activities in emerging markets. We have to acknowledge that his ap- proach is enjoying growing support among investment banks and auditing firms. At the same time, it is to be noted that Damodaran’s concept has failed to res- onate sufficiently with the academic community. This is reason enough to perform a systematic analysis and critical discussion of his country risk premium concept. Damodaran’s initial considerations concerning a country risk premium can be found in Damodaran (1999a) and Damodaran (2003), with further essentially unchanged mentions in his more recent publications. In our contribution we will concentrate on the two aforementioned sources.
2 CRP concept
In the following, we intend to give a neutral, that is, non-judgmental description of Damodaran’s country risk premium concept (CRPC). We will also attempt to provide a detailed reconstruction of Damodaran’s thought process which led to this approach.
Risk-return models The cost of capital for risk-return models can be cate- gorised as expected returns. Damodaran begins his considerations by concluding that within the framework of capital market models with J risk factors, the rela- tionship J
expected return = rf + X RP j · βj
applies at all times, where rf represents the risk-free interest rate, RP j the risk premium for the j-th factor and βj the j-th beta factor. In the special case of CAPM, which is a single-factor model, this can be simplified to
expected return = rf + MRP · β,
where MRP is referred to as the market risk premium. On the condition that the risk-free interest rate is known, risk premiums and beta factors must be estimated for all J risk factors. Damodaran generally defines a risk premium RP j as an excess return which investors achieve when they have to accept an average rate of risk for the j-th factor.
What should be measured and what is actually measured Damodaran focusses on risk premiums and, in the CAPM context, discusses what ought to be measured to later be able to compare it with what is typically measured. Under CAPM, one of the concerns is to determine the market risk premium (MRP ), which is the premium that investors demand when they invest in a well diversified portfolio of risky assets (the market portfolio). How is the MRP esti- mated? Normally, one looks at long time series to work out the historical pre- miums associated with investing into stocks as opposed to risk-free securities. According to Damodaran, such an approach can yield reasonable MRP estimates when working with US data, as the US stock market is large and diversified and both the stock market and the bond market enjoy a long history. If, however, smaller, younger markets are used, the results are meaningless. Damodaran jus-...
References: Damodaran, Aswath (1999a) Estimating equity risk premiums, Working Paper, Stern School of Business, New York University, New York.
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