You are trying to estimate the country equity risk premium for Poland. You find

Question

You are trying to estimate the country equity risk premium for Poland. You find that S&P has assigned an A rating to Poland and that Poland has issued euro-denominated Bonds that yield 7.6%. in the market currently. Germany, a AAA-rated ocuntry, has euro-denominated bonds outstanding that yield 5.1%. a) Estimate the country risk premium, usingthe default spread on the country bond as proxy. b) If you were told that the standard deviation in the Polish equity market was 25% and that the standard deviation in the polish euro bond was 15%, estimate the country risk premium.

Explanation / Answer

Country Rating of Poland = A

Yield on Poland Euro-denominated Bonds = 7.6%

Country Rating of Germany = AAA

Yield on Euro bonds = 5.1%

Standard Deviation of Polish Equity Markets = 25%

Standard Deviation of Polish Bond = 15%

From internet we can find that the rating based default spread for Germany is 0%. Then the spread between the German and Polish Bonds can be taken as rating based default spread.

The spread between the bonds of Germany and Poland is

Spread = 7.6% – 5.1% = 2.5%

Taking this as a proxy

Poland’s Country Risk Premium based on ratings can be taken as 2.5%

oland’s Country Risk Premium = Poland’s default spread * (SD of Poland equity/SD of Poland Bond)

                                                         = 2.5% * (25/15) = 2.5% * 1.666667 = 4.1667%

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