Using Sovereign Default Spreads to Estimate Equity Risk Premiums

Summary

The document questions the practice of using sovereign credit risk as an input to a country's equity risk premium. It notes that estimates may draw on ratings, bond default spreads, or credit default swap spreads, with an adjustment factor applied to translate sovereign risk into equity risk. The central issue is the economic link: sovereign distress can damage firms, especially banks and other debt holders, but the relationship may not be equally strong for all businesses.

A Greek example illustrates the method by combining a U.S. equity premium with a multiple of Greece's bond default spread to obtain a country equity premium estimate. The document asks whether sovereign spreads can exceed the appropriate equity premium, but provides no resolution or empirical evidence. It is therefore useful as a prompt about country risk estimation and the assumptions behind mapping sovereign debt risk to equity valuations, rather than as a complete estimation guide.

Key ideas

• Some country equity premium estimates use sovereign default spreads as a proxy for country risk.
• The approach applies an adjustment factor to sovereign spreads when estimating equity risk.
• Sovereign distress can affect firms through financing and economic channels, but impacts may vary by business.
• The example raises questions about whether sovereign debt risk should always imply an equal or larger equity premium.

Tags

# Why use sovereign default risk to determine equity risk premiums?


# Why use sovereign default risk to determine equity risk premiums?












Damodaran's paper "Equity Risk Premiums..." (2016) discusses the standard of using various measures of sovereign default risk (e.g. Moody's ratings, bond default spreads, CDS spreads) to estimate equity risk premiums for a country.

The implication appears to be that when a country undergoes default or debt restructure, the value of equities will suffer by an equal or greater amount than the holders of sovereign debt (Damodaran uses a 1.23 multiplier for EM). What is happening at the firm level that underpins this relationship? Sure, businesses which hold the debt will suffer (e.g. banks), but this is not the case for most businesses. Why can't the default spread for sovereign debt in an EM country be higher than the risk premium for equities in that country?

For instance, Damodaran currently estimates Greek equity risk premium as 19.90% as follows:

Greek_RP = US_equity_risk_premium + 1.23*Greek_bond_default_spread

Greek_RP = 5.69 + 1.23*11.55

Greek_RP = 19.90

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.