How do I estimate the equity risk premium for international markets?

Question

AcadiFi · Accepted Answer

The equity risk premium (ERP) for international markets requires adjustment for country-specific risks beyond the mature-market (typically US) benchmark.

Three main approaches:

1. Historical relative
ERP_country = ERP_mature × (σ_country_equity / σ_mature_equity)
Uses relative equity volatility as the risk multiplier. Simple but ignores fundamental risk differences.

2. Country Risk Premium (CRP) add-on
ERP_country = ERP_mature + CRP
CRP typically derived from sovereign credit spread adjusted for equity/bond volatility ratio (Damodaran method).

3. Implied ERP from local market
Derive directly from dividend discount model using local index, expected dividends, and current price.

For Polaris Industries (Chile) as of early 2026:
- Mature market (US) ERP: ~5.0%
- Chile sovereign spread (USD bonds vs. Treasuries): ~145 bps
- Volatility ratio (Chilean IPSA / S&P 500): 1.38
- CRP = 1.45% × 1.38 = 2.00%
- Chile ERP = 5.0% + 2.0% = 7.0%

Refinements:
- Use the company's revenue exposure across countries, not just HQ location. If Polaris sells 60% to China and 30% to Europe, blend the CRPs weighted by revenue.
- Lambda (λ) coefficient captures company-specific exposure to country risk; typically between 0.5 (multinational with diversified revenue) and 1.5 (domestic-focused small cap).
- For frontier markets with no traded sovereign bonds, use Moody's Country Risk Ratings mapped to spreads.

A pitfall: don't double-count by using local risk-free rate and local ERP without checking — if you use US Treasury as risk-free rate, the CRP captures sovereign risk.

How do I estimate the equity risk premium for international markets?

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