In the previous discussion, we laid out a rationale for excluding country risk. If you do wish to include a country-risk premium, start with the sovereign risk. The sovereign risk can be calculated by subtracting the 10-year U.S. government bond yield from a U.S. dollar-denominated local bond's stripped yield. If there is no U.S. dollar-denominated bond, subtract the inflation differential between the local country and the United States first to calculate the country sovereign-risk premium.

The next step is more controversial—subtracting the credit risk embedded in the yield. This is an attempt to estimate the cost of equity. Again, we do not believe that it is appropriate to include the risk of default and credit deterioration that make up the credit risk of a bond in the cost of equity calculation. The market-risk premium for equity already includes the possibility of losing your investment and so to include that risk again represents double counting.

So how do we eliminate the credit risk? There is no exact way to determine what part of the country-risk premium is associated with credit risk, so we approximate. Assume that since the bondrating companies have standard criteria for rating bonds worldwide, the premium on bonds with a particular rating is similar across all bonds. The premium associated with a particular rating is readily available for U.S. corporate bonds from the bond rating agencies. The premium for a BB-rated bond can be estimated by taking the difference between the yield to maturity on 10-year BB-rated U.S. corporate bonds and the 10-year U.S. government bonds. This can be used as a proxy for the credit-risk premium included in the country's yield to maturity, whose debt is rated BB. Argentina's debt is rated BB and its country-risk

Exhibit 19.10 How to Calculate the Country Risk Premium—Argentine Example

Exhibit 19.10 How to Calculate the Country Risk Premium—Argentine Example

premium is calculated in Exhibit 19.10 as an example. Note that this calculation is for the country-risk premium at a certain point in time. The country-risk premium varies significantly. The question becomes which country-risk premium to use, the current market estimate or a long-run estimate? If a long-run estimate is used, shouldn't the country-risk premium decline to zero, as the country's market becomes more stable and open? In general, we recommend starting with the current estimate and taking it down to zero at least by the end of the explicit forecast period.

Beta

The beta, a measure of a company's systematic risk, is often difficult to calculate accurately in emerging markets, where the equity market is illiquid and often dominated by a small number of stocks. Additionally, historical data do not go back far enough to have appropriately large sample sizes for reliable regressions. Beta estimation through regressions is therefore likely to be flawed.

Since we assume that emerging markets are globalizing, we generally recommend using a global industry beta relevered to the company's target capital structure. Using a comparable global industry beta provides a truer picture of the risk inherent in the company than a regression of the company's returns against the returns of the local market. We also suggest doing a range of value estimates by using several betas. For Pao de Ajucar, a Brazilian supermarket company, we would probably use two estimates of beta; the Barra predicted beta of 1.0 and the comparable industry beta (adjusted for leverage) of .85, as shown in Exhibit 19.11.