Calculating Cost of Equity for EM countries

Again from Adrian Buckley's Multinational Finance pp 481.

Cost of Equity = Comparable Domestic Return + Country Risk Premium

Country Risk Premium = Default Spread for EM Country X (Std Dev. for EM equity market/ Std Dev. for EM government bonds.)

Default Spread = EM government bonds yields - Comparable Domestic government bonds.

This is the spread between the emerging market government bond yields and a comparable domestic bond i.e. US Treasury Bond.

Cost of Equity for Emerging Markets

The following was sourced from Adrian Buckley's Multinational Finance, ch 24, pp 481 "International Investment: what discount rate?"

24.10 - Emerging Markets

[preceding this section was a discussion on the choice between an arbitrary extra risk premium when calculating discount rates for projects in EM countries and the International CAPM.]

Hooke(1998), for example, reckons that the cost of equity capital for emerging markets can be conceptualized as being equal to a comparable domestic return plus a foreign risk premium ranging between 5 percent and 15 percent.

Thus he recommends target returns for low-risk emerging markets, for example, Poland, the Czech Republic and Chile, at 18-20 per cent.

For medium-risk markets, such as Brazil, India, Indonesia and Mexico, Thailand and Turkey, he reports a recommended return of 20-25 per cent.

And for high risk countries, his cost of equity is between 25 and 30 per cent. Into this group, he categorizes China, Peru and Russia.

25 - 30 per cent Cost of Equity is a very large number to plug into your bog-standard Weighted Average Cost of Capital calculations. Unless you've got lots of debt in your capital structure, a 25 - 30% cost of equity, will discount your future cash flows by a lot. For investors, this means that Chinese and Russian stocks should trade at lower prices, given the risk they bear.