Valuation in High Growth Markets: Capturing Country Risk in the Cost of Equity Capital

This paper adds to the understanding and transparency of equity pricing in emerging markets. Its novel contribution is that it empirically investigates the pricing of Country Risk in BRIC markets, using a two-factor intertemporal pricing model. Bridging the gap between academics and practitioners, this paper contributes to the debate as to whether or not it is justified to adjust discount rates for emerging market companies – as given by the CAPM – by including an unconditional country risk premium. In choosing between country risk proxies, the sovereign yield spread adjusted for relative equity volatility appears to supersede the classical sovereign yield spread in explaining return variations. Evidence is presented that country risk is priced in India and China indicating some type of market segmentation; in these markets, the addition of a country risk premium to the discount rate is justified. Moreover, the paper complements the market integration literature in that it is shown that the correlation between the change in country risk premium and the equity risk premium might show signs of market segmentation or market integration, rendering the pricing factor for country risk in specific countries significant or insignificant, respectively. © 2010 Soeriowardojo, G.T. All rights reserved. Självständigt arbete på avancerad nivå (masterexamen) 20 poäng / 30 hp Självständigt arbete på avancerad nivå (masterexamen) 20 poäng / 30 hp This paper adds to the understanding and transparency of equity pricing in emerging markets. Its novel contribution is that it empirically investigates the pricing of Country Risk in BRIC markets, using a two-factor intertemporal pricing model. Bridging the gap between academics and practitioners, this paper contributes to the debate as to whether or not it is justified to adjust discount rates for emerging market companies – as given by the CAPM – by including an unconditional country risk premium. In choosing between country risk proxies, the sovereign yield spread adjusted for relative equity volatility appears to supersede the classical sovereign yield spread in explaining return variations. Evidence is presented that country risk is priced in India and China indicating some type of market segmentation; in these markets, the addition of a country risk premium to the discount rate is justified. Moreover, the paper complements the market integration literature in that it is shown that the correlation between the change in countr