Incorporation of Country Risk Premium to the Discount Rate
According to Damodaran, country risk premium must be included in the discount rate only if the risks of investment may be diversified. For example, if one is investing in such countries as Malaysia or Brazil, they must evaluate the market risk. If the market risk may be transformed, the additional risk premium should not be charged. On the other hand, if the market risk is not alterable, estimating a country risk premium may be a better solution.
Another important factor to take into account, when considering charging country risk premium, is the monetary policy framework. According to Fouejieu and Roger, “Adoption of inflation targeting is found to reduce risk premia”. However, it is also evident that while targeting adoption of inflation indeed has an effect on the country risk premium overall, the risk premium itself also benefits from the successful delivery of low, stable inflation by the implementation of inflation targeting. Furthermore, less developed countries may perceive adoption of inflation as a signal of authorities to commit to improvement in macroeconomic policy and promote institutional reforms.
One has also to take into account the factors that determine the country risk premium. Those factors may be divided into the influence that debt and fiscal policy has; the vulnerabilities of the balance sheet; international and institutional factors. The most important of these is, however, the level of a country’s external debt.
To summarize, when one is considering including country risk premium in the discount rate for an investment opportunity, one has to pay attention to the possibility of diversifying the risks of investment. Additionally, it is necessary to take into account targeting adoption of inflation which may also contribute to higher chances of success.