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How Do Countries Around the World Compensate for Equity Risk?

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Equity Risk Premiums

Equity Risk Premiums

How Do Countries Compensate Investors for Equity Risk?

When investors purchase stocks internationally, they are exposed to additional risks. Companies may have higher volatility based on a country’s economic, political, and legal conditions. In exchange for taking on the additional risk, investors demand a higher return potential, known as an equity risk premium.

Which countries have the highest premiums? In this Markets in a Minute from New York Life Investments, we explore equity risk premiums for countries around the world.

Behind the Numbers

The premiums are based on a study by a New York University researcher, Aswath Damodaran. All data is as of July 1, 2020.

Here are the steps Damodaran took to determine a country’s equity risk premium:

StepExample - Brazil
1. Find a country’s credit (bond) risk rating.Credit risk rating: Ba2
2. Based on that rating, determine the credit spread, which is the additional yield over a risk-free investment.Credit spread for Ba2 rating = 3.53%
3. To account for the additional risk stocks carry over bonds, multiply the credit spread by the relative equity market volatility.

This is the country risk premium.
3.53% credit spread x 1.25 relative equity market volatility

= 4.41% country risk premium
4. Add the country risk premium to the mature market risk premium (obtained by using the S&P 500 risk premium).4.41% country risk premium + 5.23% mature market risk premium
5. The resulting value is the country equity risk premium.9.64% country equity risk premium

Premiums will shift over time as a country’s credit rating, credit spread, and equity market volatility changes.

Equity Risk Premiums by Country

Below, we look at how equity risk premiums break down for 177 countries and regions, organized from highest to lowest.

CountryEquity Risk Premium
Sudan27.14%
Venezuela27.14%
Yemen, Republic27.14%
Algeria22.86%
Argentina22.86%
Guinea22.86%
Haiti22.86%
Korea, D.P.R.22.86%
Lebanon22.86%
Liberia22.86%
Somalia22.86%
Syria22.86%
Zambia22.86%
Zimbabwe22.86%
Ecuador19.92%
Congo (Republic of)18.46%
Cuba18.46%
Iran18.46%
Libya18.46%
Malawi18.46%
Mozambique18.46%
Sierra Leone18.46%
Barbados16.25%
Belize16.25%
Congo (Democratic Republic of)16.25%
Gabon16.25%
Guinea-Bissau16.25%
Iraq16.25%
Angola14.79%
Belarus14.79%
Bosnia and Herzegovina14.79%
El Salvador14.79%
Gambia14.79%
Ghana14.79%
Madagascar14.79%
Maldives14.79%
Mali14.79%
Moldova14.79%
Mongolia14.79%
Myanmar14.79%
Nicaragua14.79%
Niger14.79%
Pakistan14.79%
Solomon Islands14.79%
St. Vincent & the Grenadines14.79%
Suriname14.79%
Tajikistan14.79%
Togo14.79%
Ukraine14.79%
Bahrain13.32%
Benin13.32%
Burkina Faso13.32%
Cambodia13.32%
Cameroon13.32%
Cape Verde13.32%
Costa Rica13.32%
Egypt13.32%
Ethiopia13.32%
Guyana13.32%
Jamaica13.32%
Kenya13.32%
Kyrgyzstan13.32%
Nigeria13.32%
Papua New Guinea13.32%
Rwanda13.32%
Sri Lanka13.32%
Swaziland13.32%
Tunisia13.32%
Uganda13.32%
Albania11.84%
Bolivia11.84%
Cook Islands11.84%
Greece11.84%
Honduras11.84%
Jordan11.84%
Montenegro11.84%
Tanzania11.84%
Turkey11.84%
Uzbekistan11.84%
Armenia10.52%
Bangladesh10.52%
Côte d'Ivoire10.52%
Dominican Republic10.52%
Fiji10.52%
Macedonia10.52%
Oman10.52%
Senegal10.52%
Serbia10.52%
Vietnam10.52%
Azerbaijan9.64%
Bahamas9.64%
Brazil9.64%
Croatia9.64%
Cyprus9.64%
Georgia9.64%
Namibia9.64%
Guatemala8.90%
Morocco8.90%
Paraguay8.90%
South Africa8.90%
Trinidad and Tobago8.90%
Hungary8.46%
India8.46%
Italy8.46%
Kazakhstan8.46%
Montserrat8.46%
Portugal8.46%
Romania8.46%
Russia8.46%
St. Maarten8.46%
Andorra (Principality of)8.03%
Bulgaria8.03%
Colombia8.03%
Curacao8.03%
Indonesia8.03%
Philippines8.03%
Sharjah8.03%
Uruguay8.03%
Aruba7.58%
Mauritius7.58%
Mexico7.58%
Panama7.58%
Slovenia7.58%
Spain7.58%
Thailand7.58%
Turks and Caicos Islands7.58%
Laos6.99%
Latvia6.99%
Lithuania6.99%
Malaysia6.99%
Peru6.99%
Bermuda6.48%
Botswana6.48%
Brunei6.48%
Iceland6.48%
Ireland6.48%
Malta6.48%
Poland6.48%
Ras Al Khaimah (Emirate of)6.48%
Slovakia6.48%
Chile6.26%
China6.26%
Estonia6.26%
Israel6.26%
Japan6.26%
Saudi Arabia6.26%
Belgium6.12%
Cayman Islands6.12%
Czech Republic6.12%
Guernsey (States of)6.12%
Hong Kong6.12%
Jersey (States of)6.12%
Macao6.12%
Qatar6.12%
Taiwan6.12%
Abu Dhabi5.96%
France5.96%
Isle of Man5.96%
Korea5.96%
Kuwait5.96%
United Arab Emirates5.96%
United Kingdom5.96%
Austria5.81%
Finland5.81%
Australia5.23%
Canada5.23%
Denmark5.23%
Germany5.23%
Liechtenstein5.23%
Luxembourg5.23%
Netherlands5.23%
New Zealand5.23%
Norway5.23%
Singapore5.23%
Sweden5.23%
Switzerland5.23%
United States5.23%

Venezuela, Sudan, and Yemen are tied for the highest equity risk premium. While Venezuela battles hyperinflation, Yemen is suffering from a humanitarian crisis and Sudan has high perceived corruption.

In the mid-range, emerging countries such as Brazil, South Africa, and India carry moderate risk. However, they may also provide investors with higher returns than can be expected in mature markets.

On the low end of the scale, countries such as the United States, Singapore, and Germany have AAA credit ratings and the lowest premium of 5.23%.

Applying Risk Premiums to Companies

How can investors determine the equity risk premiums for individual companies?

One method is to assume that all companies incorporated in a country have equal exposure to that country’s risk. However, this is a simplified approach and does not account for the fact that a company’s operations may extend into other markets.

Alternatively, investors can calculate a weighted-average premium based on the location of a company’s revenue or production. For example, a consumer products business may weigh exposure based on the location of their revenue. An oil and gas company, where true risk lies in their reserves rather than where they sell, may instead be weighted by production.

Here’s a hypothetical example for an oil & gas company that has reserves in the United States, Saudi Arabia, and Venezuela:

CountryProduction (in kboed)*% of TotalEquity Risk Premium
Total300100%14.41%
U.S.6020%5.23%
Saudi Arabia12040%6.26%
Venezuela12040%27.14%

* Kilobarrels of oil equivalent per day.

The weighted-average equity risk premium is 14.41%.

Importantly, even countries headquartered in mature markets have international risks if they carry out operations in other countries.

Risk Vs. Potential Reward

Every country presents varying degrees of risk based on local conditions. As investors look to diversify internationally, it’s critical to consider two factors:

  • The additional risk
  • The potential additional return

Equity risk premiums serve as a guide that can help investors compare country risk, and the additional return potential they should expect for tolerating that risk.

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Markets in a Minute

Infrastructure Megatrends: The Clean Energy Transition

Governments are keen to make the transition to clean energy, but what will it take to get there? In this chart, we examine two scenarios through 2050.

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Infrastructure Megatrends: The Clean Energy Transition

Demand for clean energy is ramping up as a majority of countries target 2050 as the year to achieve net-zero emissions. But how much will this all cost?

According to the International Renewable Energy Agency (IRENA), upwards of $100 trillion is needed to build a system capable of keeping global temperatures from rising above 2C° (3.6F°).

In this Markets in a Minute chart from New York Life Investments, we take a closer look at the outcomes of such a massive endeavor.

Investment Required to Reshape Global Energy Markets

The IRENA believes there are two scenarios for how the clean energy transition plays out by 2050.

Their first scenario involves a total investment of $95 trillion (112% of global GDP in 2020) and is based on current policies and targets. Despite the lofty amount, this scenario is expected to fall short in achieving the goals set by the Paris Agreement.

Their second scenario involves a more ambitious set of targets, as well as a 16% larger investment of $110 trillion. Thanks to economies of scale, this scenario will reduce carbon emissions much further and keep the global temperature rise below 2C° (3.6F°).

The estimates behind these two scenarios are outlined in the table below.

 Current SituationScenario 1 ($95T in investment)Scenario 2 ($110T in investment)
Renewable Share in Electricity Generation26%55%86%
Electrification Share of Final Energy20%30%49%
Energy-Related CO2 Emissions (gigatonnes)34gt 33gt
9.5gt

How Do We Get There?

For scenario 2 to become reality, significant changes would need to be made across the entire economy.

For starters, the IRENA estimates that 1.1 billion electric vehicles will be on the road by 2050, up from 8 million in 2019. The resulting need for charging infrastructure is reflected by Scenario 2’s higher share of electrification (49% vs 30%).

Government subsidies around the world would also need to be adjusted, with much less money flowing to fossil fuels. The chart below provides a roadmap for these adjustments—on the left is the dollar value of subsidies, and on the right is each segment’s share of the total.

Government energy subsidies

Fossil fuel subsidies in the U.S. are facilitated through tax cuts, and are estimated to be worth around $20 billion per year. This may change very soon, as the Biden administration has signaled its intention to eliminate these subsidies as part of its 2021 tax plan.

With Great Change Comes Great Opportunity

The demand for clean energy is expected to kick-off a monumental transformation of the world’s infrastructure.

For investors, gaining exposure to this megatrend may combine attractive return potential with positive environmental impact. In fact, many listed companies in the utilities sector are establishing themselves as leaders in this regard.

Consider Enel, an Italian multinational with activities in Europe and the U.S. The firm has directed capital towards renewable energy since 2015 and is now the world’s largest player in renewables with 46GW of installed capacity across solar, wind, and hydro.

Further developments are planned, and Enel expects to grow its earnings (represented by EBITDA) at a compound annual growth rate (CAGR) of 5%-6% over the next decade.

To learn more about the opportunities surrounding clean energy, consider this infographic on the global sustainable recovery.

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Markets in a Minute

Can Foreign Currencies Act as an Inflation Hedge?

To determine if foreign currencies were a good inflation hedge, we looked at their performance relative to U.S. inflation over the last four decades.

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Inflation Hedge

This infographic is available as a poster.

Can Foreign Currencies Act as an Inflation Hedge?

Inflation is like corrosion. Initially, it can make investment returns less attractive. Over time, it can significantly eat away at an investment’s value. For U.S. investors looking for an inflation hedge, holding foreign currencies may be one option.

But just how effective are they at managing inflation risk? In this Markets in a Minute chart from New York Life Investments, we look at how the performance of foreign currencies compared to U.S. inflation rates over the last four decades.

How to Hedge Against Inflation

Inflation reduces the value of a dollar over time. To manage this risk, investors look for returns that are higher than the inflation rate. For example, a currency that appreciates 6% during 2% inflation may be considered a relatively good inflation hedge.

What makes a currency appreciate? A currency will perform well against the U.S. dollar if investors consider the issuing economy to be strong. This is because foreign investors will look to purchase investments in the applicable currency, driving up its demand.

Foreign Currency Appreciation vs. U.S. Inflation

Here is how the four largest non-U.S. reserve currencies have performed from 1981-2020. We measured a foreign currency’s appreciation against the U.S. dollar using annual exchange rates. U.S. inflation was measured by the percentage change in the average consumer price index for all urban consumers. Neither metric was seasonally adjusted.

YearAverage U.S. InflationEuropean euroChinese yuanJapanese yenBritish pound
20201.2%1.9%0.1%2.1%0.5%
20191.8%-5.6%-4.5%1.3%-4.7%
20182.4%4.4%2.2%1.5%3.5%
20172.1%2.0%-1.8%-3.2%-5.2%
20161.3%-0.2%-5.7%10.2%-12.8%
20150.1%-19.8%-2.0%-14.5%-7.9%
20141.6%0.1%-0.2%-8.3%5.1%
20131.5%3.2%2.6%-22.3%-1.4%
20122.1%-8.3%2.4%-0.2%-1.2%
20113.1%4.8%4.5%9.2%3.7%
20101.6%-5.1%0.9%6.3%-1.4%
2009-0.3%-5.7%1.7%9.4%-18.4%
20083.8%6.9%8.7%12.2%-8.0%
20072.9%8.4%4.6%-1.3%7.9%
20063.2%0.9%2.7%-5.6%1.3%
20053.4%0.1%1.0%-1.8%-0.7%
20042.7%9.0%0.0%6.7%10.8%
20032.3%16.5%0.0%7.4%8.1%
20021.6%5.3%0.0%-3.0%4.2%
20012.8%-3.1%0.0%-12.8%-5.3%
20003.4%-15.4%0.0%5.2%-6.7%
19992.2%N/A0.3%13.2%-2.5%
19981.5%N/A0.2%-8.2%1.2%
19972.3%N/A0.2%-11.3%4.7%
19962.9%N/A0.4%-15.8%-1.1%
19952.8%N/A3.1%8.0%3.0%
19942.6%N/A-49.5%8.0%2.0%
19933.0%N/A-4.7%12.4%-17.6%
19923.0%N/A-3.5%5.8%-0.1%
19914.2%N/A-11.3%7.2%-0.9%
19905.4%N/A-27.2%-5.0%8.2%
19894.8%N/A-1.0%-7.7%-8.7%
19884.1%N/A0.0%11.4%7.9%
19873.6%N/A-7.8%14.1%10.5%
19861.9%N/A-17.6%29.4%11.6%
19853.5%N/A-26.3%-0.4%-3.0%
19844.4%N/A-17.6%0.0%-13.4%
19833.2%N/A-4.4%4.6%-15.3%
19826.2%N/A-11.0%-12.9%-15.8%
198110.4%N/A--2.7%-14.8%

Note: The euro was created in 1999, which is why annual appreciation data against the U.S. dollar is not applicable prior to 2000. The Chinese yuan / U.S. dollar foreign exchange rate was not available for 1980, which is why annual appreciation for 1981 is unavailable.

The Best and Worst Inflation Hedges, Historically

Based on available data, here is the percentage of time each currency’s annual appreciation was greater than the U.S. inflation rate.

European euroChinese yuanJapanese yenBritish pound
43%18%48%33%

The Japanese yen acted as the best inflation hedge, with its annual appreciation beating U.S. inflation 48% of the time. Demand for the safe haven currency has historically been strong for three main reasons:

  • After the Japanese banking crisis of the late 1990s, the government introduced a number of policy measures. This helped Japan enter the global financial crisis with a relatively stable banking system.
  • Japan is the largest creditor nation, meaning the value of foreign assets held by Japanese investors is higher than the value of Japanese assets owned by foreign investors. In times of market uncertainty, the money of Japanese investors tends to return home—driving up demand for the yen.
  • To take advantage of near-zero interest rates in Japan, investors conduct “carry trades” where they borrow funds in Japan and lend or invest in countries where returns are higher. During turbulent markets, investors may unwind these trades, furthering demand for the yen.

The Chinese yuan has been the worst inflation hedge, with the yuan’s appreciation beating U.S. inflation only 18% of the time since 1982. This is perhaps not surprising, given that the yuan was pegged against the U.S. dollar in 1994 to keep the yuan low and make China’s exports competitive.

In 2005, China moved to a “managed float” system where the price of the yuan is allowed to fluctuate in a narrow band relative to a basket of foreign currencies. This shift led to the yuan appreciating against the U.S. dollar in some years.

The Risks of Currency as an Inflation Hedge

As the chart makes clear, investing in foreign currencies can be very volatile. Not only can currency depreciation lead to losses, there are additional factors for investors to consider such as geopolitical risks.

Of course, the effectiveness of foreign currencies as an inflation hedge depends on their attractiveness relative to the U.S. dollar. If a country is also affected by the factors causing U.S. inflation—such as an increase in the money supply—its currency could be negatively affected.

Given the uncertainties associated with this strategy, investors may want to consider foreign currencies alongside other asset classes to help manage inflation risk.

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