FRM Exam Part I · Country Risk: Determinants, Measures, and Implications

How to Calculate Country Equity Risk Premium

Updated 11 October 2026 · Fact-checked

The country equity risk premium is the extra return investors demand for equity in a risky country. Estimate it as the sovereign default spread times the ratio of equity volatility to bond volatility. Then add it to the mature market premium to get the total equity risk premium for that country.

Understand Equity Risk Premium and Country Risk Premium

An equity risk premium is the extra return investors expect from stocks over a risk-free rate. In a mature market such as the US, you can estimate it from long history. In a riskier country, equity holders face extra risks: sovereign default, currency crises, weak institutions and political shocks. They demand more than the mature market premium.

The extra amount is the country risk premium (CRP). The most common approach starts from the sovereign default spread: the yield on the country's government bond (in USD or EUR, to avoid currency effects) minus the yield on a default-free bond in the same currency. The spread is the bond market's price for default risk.

A bond spread is not an equity premium. Equities are riskier than the government's bonds, so the spread understates the equity penalty. You fix this by scaling the spread by the relative volatility: the standard deviation of the country's equity market divided by the standard deviation of its government bond. If equities are twice as volatile as the bonds, the CRP is about twice the spread.

The total premium is then: mature market premium + CRP. A company or project in that country can use this total premium in a CAPM-style cost of equity. You can also apply it through beta, but the basic version in this topic adds the CRP in full.

This is an estimate, not an exact law. It assumes the bond spread reflects default risk only and that the volatility ratio is stable. Spreads also include liquidity and risk-appetite effects, so treat the result as a reasoned approximation.

Key formulas to remember

Sovereign default spread: Default spread = Yield on country's government bond (in USD or EUR) − Yield on default-free bond of same currency and maturity; Use the same currency and similar maturity. Otherwise inflation or term differences contaminate the spread.
Country risk premium (CRP): CRP = Default spread × (σ equity ÷ σ government bond); The ratio is the relative volatility of the country's equity market to its bond market. It is usually above 1.
Total equity risk premium: ERP (country) = ERP (mature market) + CRP; Simple additive form. Mature market premium is typically from a market like the US.
Cost of equity with country risk: Cost of equity = Risk-free rate + β × ERP (mature) + CRP; This version adds the CRP in full, without scaling by beta. Read the question to see whether beta applies to CRP.

How to solve Equity Risk Premium and Country Risk Premium questions

Use this order for any question on the equity risk premium and country risk premium.

1Identify the mature market equity risk premium given in the question.
2Find the sovereign default spread. If you get two yields, subtract the default-free yield from the country's yield. Check both are in the same currency.
3Find the relative volatility. If you get standard deviations, divide the equity σ by the bond σ.
4Compute CRP = default spread × relative volatility.
5Add CRP to the mature market premium to get the country's total ERP.
6If asked for cost of equity, add the risk-free rate and apply beta as the question states.
7Check the size: CRP should be larger than the default spread when equity σ exceeds bond σ.

Quickest way: Spread times ratio, then add

When to use it: Use this when the question gives all inputs and asks for CRP or total premium in one calculation.

Write spread (as a decimal), ratio, and mature premium on one line.
Multiply spread by ratio: this is CRP.
Add the mature premium.
Convert back to a percent and compare with the options: the right answer should be above the mature premium.

Common mistakes in Equity Risk Premium and Country Risk Premium

Using the default spread as the CRP without scaling.
The spread feels like the premium already, and the scaling step is easy to forget.
Fix: Always ask whether the question gives volatilities. If it does, multiply the spread by σ equity ÷ σ bond.
Inverting the volatility ratio (bond σ ÷ equity σ).
Students rush and mix up numerator and denominator.
Fix: Equity goes on top. Equities are normally more volatile, so the ratio should be above 1.
Forgetting to add the mature market premium.
The CRP is the number you just computed, so it looks like the answer.
Fix: Re-read the question. If it asks for the country's total ERP or cost of equity, add the mature premium.
Computing the spread with bonds in different currencies.
Students subtract any two yields given in the data.
Fix: Subtract only yields in the same currency, such as a USD-denominated sovereign bond minus the US Treasury yield.
Mixing percentages and decimals.
Spreads are quoted in basis points, premiums in percent.
Fix: Convert everything to percent or decimal first. 250 bp = 2.50% = 0.025.

Worked examples

Example 1

The mature market equity risk premium is 5.0%. A country's USD-denominated government bond yields 7.2%, while the US Treasury of similar maturity yields 4.2%. The country's equity market has annual volatility of 24% and its government bond has volatility of 16%. Calculate the country's total equity risk premium.

Show the solution

Default spread = 7.2% − 4.2% = 3.0%.
Relative volatility = 24% ÷ 16% = 1.5.
CRP = 3.0% × 1.5 = 4.5%.
Total ERP = 5.0% + 4.5% = 9.5%.

Answer: The country's total equity risk premium is 9.5%.

Example 2

An analyst values a company in an emerging market. The risk-free rate is 4.0%, the company's beta is 1.2, the mature market premium is 5.5%, and the sovereign default spread is 250 bp. Equity volatility is 30% and government bond volatility is 20%. Using the approach that adds the CRP in full, find the cost of equity.

Show the solution

Default spread = 250 bp = 2.5%.
Relative volatility = 30% ÷ 20% = 1.5.
CRP = 2.5% × 1.5 = 3.75%.
Beta times mature premium = 1.2 × 5.5% = 6.6%.
Cost of equity = 4.0% + 6.6% + 3.75% = 14.35%.

Answer: The cost of equity is 14.35%.

Exam tips

Read the units. Spreads are often in basis points while premiums are in percent. Convert before multiplying.
Check which volatility is the numerator. Equity σ is on top.
Look for the phrase that tells you whether beta scales the CRP. Unless stated, add CRP in full.
Use the options as a sense check: the total ERP must exceed the mature premium, and the CRP should exceed the spread if the ratio is above 1.
Watch for distractors such as the risk-free rate, which is not part of the premium itself.

Practice questions from Country Risk: Determinants, Measures, and Implications

Equity Risk Premium and Country Risk Premium in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Equity Risk Premium and Country Risk Premium: frequently asked questions

What is the formula for country risk premium?

CRP = sovereign default spread × (σ equity ÷ σ government bond). The default spread is the country's bond yield minus a default-free yield in the same currency. The ratio scales the bond-based spread up to an equity-based premium.

Why scale the default spread by relative volatility?

The spread measures the extra yield on a bond, which is less risky than equity. Equity is usually more volatile than the bond, so the same country risk costs equity holders more. The ratio converts the bond premium to an equity premium.

How do I get the total equity risk premium for a country?

Add the country risk premium to the mature market equity risk premium. For example, 5.0% mature premium plus 4.5% CRP gives 9.5%. This total can then feed a cost of equity calculation.

Should the default spread use local currency bonds?

No. Use bonds in the same hard currency as the default-free benchmark, such as USD or EUR. Local currency yields include inflation and currency expectations, which are not default risk.