Estimating the Country Risk Premium in Emerging Markets: the Case of the Republic of Macedonia

Abstract

Estimation of the cost of capital is difficult in developed markets and even more difficult in emerging markets. Investments in the emerging markets are more risky than in the developed markets but return is also higher. The key question here is whether the return on investments in emerging markets should be rewarded by compensation in excess of that provided by an equivalent investment in a developed market. Contemporary literature provides alternative ways for calculating the cost of capital invested in emerging markets. In general, it can be concluded that it is widely accepted that country risk matters when investing in emerging markets and it is a key component in the estimation of the cost of capital for those investments. Country risk is non-diversifiable, which will be argued in this paper first, after which an alternative approach will be provided for quantification of country risk in the risk premium measure, which is integral component in the models for estimating the cost of capital.