Need Help on the use of ERP of a country and CRP. when to use which one?
Through my studies this is what I have understood till now. When we are trying to value a company that is in another country. We will have add up the country risk with the calculation So ERP for India = ERP for US + default spread of India (This is the case for emerging market. Where the US is the developed market)
But further more I also observe the use of country Risk premium CRP to calculate cost of equity.
CRP = default spread of a country * (1+ scaling factor) Now I'm confused on what to use?? Can someone help me with this problem
Ah, the old ERP vs CRP conundrum! It's a classic one. Let's break it down, shall we?
When you're valuing a company in another country, especially an emerging market, you're absolutely right that you need to consider the country risk. The Equity Risk Premium (ERP) for a country like India would indeed be the ERP for the US (a developed market) plus the default spread for India. This approach gives you a measure of the additional risk associated with investing in a country like India compared to a developed market like the US.
Now, the Country Risk Premium (CRP) is another way to account for the risk associated with investing in a particular country. The formula you've mentioned, CRP = default spread of a country * (1+ scaling factor), is one way to calculate it. The scaling factor is used to adjust the default spread for the volatility of the equity market relative to the bond market in that country.
So, when to use which? Well, it depends on the specific circumstances and what you're most comfortable with. Both ERP and CRP are ways to account for country risk, and they should give you similar results. If you're more comfortable with the ERP approach, go for it. If you prefer the CRP approach, that's fine too. The key is to be consistent in your approach and to understand the assumptions and limitations of whichever method you choose.
Remember, there's no one-size-fits-all answer in finance. It's all about making informed decisions based on the best available data and your understanding of the situation. Keep up the good work!
Sources: Q&A: Emerging markets investment analyst, January 2016 Data Update 1: The US Equity Markets, Notes for Technical Interview Questions
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