Country Risk

Measuring Company Exposure to Country Risk: Theory and Practice
Aswath Damodaran
Stern School of Business
adamodar@stern.nyu.edu
September 2003

Country Risk and Company Exposure: Theory and Practice
The growth of financial markets in Asia and Latin America and the allure of
globalization has made the analysis and assessment of country risk a critical component
of valuation in recentyears. In this paper, we consider two issues. The first is the whether
country risk should be considered explicitly in valuation, and if the answer is yes, how to
do it. Generically, there are two ways of incorporating country risk; we can either adjust
the cash flows or change the discount rate and we will consider both approaches. The
second and equally important issue is how to assess acompany’s exposure to country risk
and we will emphasize two points. The first is that not all companies in an emerging
market are equally exposed to country risk and that we need to differentiate between
firms. The second is that a company’s exposure to country risk comes not from where it
incorporates and trades but from where it does its business. In other words, assessing and
dealing withcountry risk can be important even for companies that trade in developed
markets, if they get a significant portion of their revenues in emerging markets.

As companies and investors globalize and financial markets expand around the
world, we are increasingly faced with estimation questions about the risk associated with
this globalization. When investors invest in Petrobras, Gazprom and ChinaPower, they
may be rewarded with higher returns but they are also exposed to additional risk. When
Coca Cola and Nestle push for growth in Asia and Latin America, they clearly are
exposed to the political and economic turmoil that often characterize these markets.
In practical terms, how, if at all, should we adjust for this additional risk? In the
first part of the paper, we will review thediscussion on country risk premiums and how
to estimate them. In the latter part of the paper, we will focus on a related question: Once
we have estimated a country risk premium, how do we evaluate a company’s exposure to
country risk? In the process, we will argue that a company’s exposure to country risk
should not be determined by where it is incorporated and traded. By that measure, neitherCoca Cola nor Nestle are exposed to country risk. Exposure to country risk should come
from a company’s operations, making country risk a critical component of the valuation
of almost every large multinational corporation.

Country Risk
There are two key questions that we face when we are asked to evaluate emerging
markets in Asia, Latin America and Eastern Europe. The first relates towhether there
should be an additional risk premium when valuing equities in these markets, because of
the country risk. As we will see, the answer will depend upon whether we view markets
to be open or segmented and whether we believe in a one-factor or a multi-factor model.
The second question relates to estimating an equity risk premium for emerging markets.
Depending upon our answer to thefirst question, we will consider several solutions.
Should there be a country risk premium?
Is there more risk in investing in Malaysian or Brazilian equities than there is in
investing in equities in the United States? The answer, to most, seems to be obviously
affirmative. That, however, does not answer the question of whether there should be an
additional risk premium charged when investingin those markets.
Note that the only risk that is relevant for purposes of estimating a cost of equity
is market risk or risk that cannot be diversified away. The key question then becomes

whether the risk in an emerging market is diversifiable or non-diversifiable risk. If, in
fact, the additional risk of investing in Malaysia or Brazil can be diversified away, then
there should be no...