What is the total risk ERP approach and when should I use it?

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AcadiFi · Accepted Answer

The total risk ERP approach measures expected return based on a country's total equity volatility relative to a mature market, rather than systematic risk alone. When systematic-only fails: Standard CAPM assumes investors hold globally diversified portfolios, so only systematic (beta) risk matters. Reality: - Local investors hold mostly domestic assets (home bias) - Private companies or family-held businesses can't easily diversify - Frontier markets are segmented from global capital flows - PE/VC investments hold concentrated positions In these cases, total risk matters more than systematic risk. Formula: ERP_total_risk = ERP_mature × (σ_country / σ_mature) Example — valuing a family-held Argentine agribusiness Pampas Roja for domestic sale: - ERP_mature (US): 5.0% - σ Merval (Argentina) = 42% annualized - σ S&P 500 = 16% annualized - Ratio = 42/16 = 2.625 - ERP_total_risk = 5.0% × 2.625 = 13.13% Compare to systematic approach: - Sovereign spread 650 bps, RSVM 1.5 - CRP = 6.5% × 1.5 = 9.75% - ERP = 5.0% + 9.75% = 14.75% Both approaches give similar ballpark (~13-15%), but logic differs: - Total risk: assumes buyer is undiversified Argentine investor - Systematic: assumes global investor with partial Argentine exposure When to use total risk: 1. Private firm valuation in EM/frontier markets 2. Local buyer/seller negotiation (not cross-border) 3. Highly concentrated investor portfolios (family offices, strategic buyers) 4. Segmented capital markets (capital controls) ```mermaid flowchart TD A[Buyer Profile] --> B{Diversified
Globally?} B -->|Yes| C[Systematic
Risk ERP] B -->|No| D[Total Risk
ERP] C --> E[Standard CAPM] D --> F[Scaled ERP] ``` Don't use total risk if: - Pricing a publicly-traded, liquid EM stock for global investors - The buyer has a diversified portfolio (even if HQ'd locally) Hybrid: use a blended ERP weighted by the percentage of the shareholder base that's global vs. local.

What is the total risk ERP approach and when should I use it?

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