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

Country Risk Premium and Equity Risk Premium for Emerging Markets

Updated 11 October 2026 · Fact-checked

A country risk premium is the extra equity return investors demand for the risk of a country. Estimate it from the sovereign default spread, then optionally scale that spread by the ratio of equity volatility to government bond volatility. Add the result to the mature market equity risk premium to get the country's total premium.

Understand Country Risk Premiums and Equity Risk Premium

Start with a mature market, such as the US. Investors there demand an equity risk premium (ERP) over the risk-free rate. This is the mature market premium. Now move to a country with higher political, economic and default risk. Investors want more than the mature premium. The extra amount is the country risk premium (CRP).

The simplest way to size it is to use the sovereign's default spread. This is the yield on the country's government bond, issued in a hard currency such as USD or EUR, minus the risk-free yield in that same currency. You can also take it from the sovereign CDS spread or from a rating-based spread. The default spread measures the extra return lenders need for default risk. It is a measure for bonds, not for equities.

Equity is riskier than a government bond. So many analysts scale the default spread up. They multiply it by relative equity market volatility: the standard deviation of the country's equity market divided by the standard deviation of the country's government bond. If equities are twice as volatile as the bond, the CRP is twice the default spread. This gives a larger premium than the default spread alone.

The final step is simple addition. Total ERP = mature market ERP + CRP. The total ERP then feeds the cost of equity. You can add the CRP to the ERP for every company in the country. Or you can scale it by each company's exposure to the country. Read the question to see which one it wants.

The key distinction for the exam: the default spread is a premium for sovereign debt. The CRP is a premium for equity. They are equal only if you assume equity risk moves one-for-one with bond risk. Usually you adjust the spread by the volatility ratio.

Key formulas to remember

Sovereign default spread: Default spread = Yield on sovereign bond (in USD or EUR) − Risk-free yield in the same currency; Both yields must be in the same currency and have similar maturity. A CDS spread or rating-based spread can stand in.
CRP from default spread: CRP = Default spread; The simplest approach. It treats sovereign default risk as the whole country premium.
CRP from relative volatility: CRP = Default spread × (σ country equity ÷ σ country government bond); The denominator is the volatility of the country's bond, not of the US equity market. The ratio is usually above 1.
Total equity risk premium: Total ERP = Mature market ERP + CRP; The mature premium comes from a market such as the US.
Cost of equity with a country premium: Cost of equity = Risk-free rate + Beta × (Mature ERP + CRP); This applies the CRP to every company equally. If the question scales the CRP by exposure, use Beta × Mature ERP + exposure × CRP.

How to solve Country Risk Premiums and Equity Risk Premium questions

Use this order for any question on country risk premiums. It keeps you from mixing up spreads, volatilities and premiums.

1Identify what you are given: a default spread (or CDS or rating spread), equity and bond volatilities, and the mature market ERP.
2Check the currency. The default spread must be measured in a hard currency over the matching risk-free rate. Do not use a local-currency bond yield without adjusting.
3Decide the method. If the question mentions volatilities, use the relative volatility method. If it gives only a spread, the CRP equals the spread.
4For the volatility method, compute the ratio: σ country equity ÷ σ country government bond. Multiply it by the default spread.
5Add the CRP to the mature market ERP to get the total ERP.
6If asked for a cost of equity, plug the total ERP into Risk-free + Beta × ERP. Use the risk-free rate in the currency of the cash flows.
7Check that the answer is sensible: total ERP must be above the mature ERP, and the CRP must not be below the default spread when the ratio is above 1.

Quickest way: Three-line shortcut for CRP questions

When to use it: Use it when the question gives numbers and four close answer options, and you have little time.

Find the ratio of the two volatilities first. It is often a clean number such as 1.5 or 2.
Multiply the default spread by that ratio to get the CRP. If no volatilities are given, the CRP is the spread.
Add the mature ERP. Then check which option matches. Options that equal the spread alone or the spread plus the mature ERP are the usual traps.

Common mistakes in Country Risk Premiums and Equity Risk Premium

Treating the default spread as the equity risk premium.
Both are called premiums over a base rate, so they look alike.
Fix: The default spread is a bond premium. To get an equity CRP, scale it by relative volatility if the question gives the data, then add it to the mature ERP.
Using the volatility ratio of the country's equity market to the US equity market in the CRP formula.
Students mix this up with other ways of scaling the ERP.
Fix: In this method the ratio is the country's equity volatility divided by the same country's government bond volatility. Read the denominator carefully.
Forgetting to add the mature market ERP and giving the CRP as the total premium.
The calculation feels finished after the CRP step.
Fix: Always finish with Total ERP = mature ERP + CRP. Then read what the question asks for: the CRP or the total.
Measuring the default spread on a local-currency bond.
Local-currency yields include inflation differences, not only default risk.
Fix: Use a USD or EUR sovereign bond and subtract the risk-free yield in that currency. A CDS spread is another clean option.
Inverting the ratio, so the bond volatility is divided by the equity volatility.
Students rush and flip the fraction.
Fix: Equity is the riskier asset, so the ratio should normally be above 1. If your ratio is below 1, check it.
Double counting country risk by adding the CRP to the ERP and also raising the risk-free rate with the sovereign spread.
Both adjustments reflect default risk.
Fix: Use one consistent approach. Keep the risk-free rate as the rate in the currency of the cash flows with no default spread, and put the country risk in the ERP.

Worked examples

Example 1

A country's USD-denominated sovereign bond yields 7.5%. The US Treasury yield of the same maturity is 4.5%. The mature market ERP is 4.5%. Using the default spread alone as the CRP, find the total ERP for the country.

Show the solution

Default spread = 7.5% − 4.5% = 3.0%.
The CRP equals the default spread, so CRP = 3.0%.
Total ERP = 4.5% + 3.0% = 7.5%.

Answer: Total ERP = 7.5%.

Example 2

A country has a sovereign default spread of 3.0%. Its equity market has an annualised standard deviation of 24% and its government bond has an annualised standard deviation of 12%. The mature market ERP is 5.0%. Risk-free rate is 4.0% and a company has a beta of 1.2. Find the CRP, the total ERP and the cost of equity, applying the CRP to the whole ERP.

Show the solution

Relative volatility = 24% ÷ 12% = 2.0.
CRP = 3.0% × 2.0 = 6.0%.
Total ERP = 5.0% + 6.0% = 11.0%.
Cost of equity = 4.0% + 1.2 × 11.0% = 4.0% + 13.2% = 17.2%.

Answer: CRP = 6.0%, total ERP = 11.0%, cost of equity = 17.2%.

Exam tips

Read what is asked: the CRP, the total ERP or the cost of equity. Wrong options are often the answers to the other two.
If volatilities appear in the stem, expect the relative volatility method. If they do not, the CRP is the default spread.
Check the currency and the denominator of the volatility ratio before calculating.
Know the logic, not only the arithmetic. Questions may ask why the default spread understates the equity CRP: equity is more volatile than the sovereign bond.
Do the sense check last. Total ERP must exceed the mature ERP, and with a ratio above 1 the CRP must exceed the default spread.

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

Country Risk Premiums and Equity 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.

Country Risk Premiums and Equity Risk Premium: frequently asked questions

What is the difference between a default spread and a country risk premium?

The default spread is the extra yield on a sovereign bond over the risk-free rate in the same currency. It prices default risk for lenders. The country risk premium is the extra return required on equity for the country's risk. It is often the default spread scaled up by relative equity volatility.

How do you estimate the equity risk premium for an emerging market?

Take the mature market ERP, such as the US premium. Estimate the CRP from the sovereign default spread, scaled by equity-to-bond volatility if data is given. Add the CRP to the mature ERP to get the emerging market ERP.

Why multiply the default spread by relative equity volatility?

Equity is riskier than the government bond of the same country. The ratio of their standard deviations gives a rough scale for how much more risk equity investors carry. A ratio of 2 doubles the CRP compared with the spread.

Should the CRP be applied to every company equally?

The simplest approach adds the CRP to the ERP for all companies in the country. A refinement scales the CRP by how exposed each company is to that country. Follow the method stated in the question.