Thedisadvantageofthisapproachisthatittarsallcompanies
inacountrywiththesamebrushandassumesthattheyareall
exposed to country risk in the same magnitude.
Thesecondapproachisalittlemorereasonable,insofarasit
scales country risk to beta by computing cost of equity as:
Totheextentthatbetathatmeasuresexposuretoallotherrisk
also measuresexposure to country risk,this approach will
workreasonablywell.However,ifcountryriskexposure is
different from other macroeconomic risk exposure, the
approach will fail.
Thethirdandmostgeneralapproachtreatscountryriskasa
separateriskcomponentandestimatesriskexposureto that
componentseparatelyfrom beta.Ifwedefinea company’s
exposureto countryrisktobeλ,thecostofequitycanbe
written as:
Thisapproachhastwosignificantadvantages.First,itallows
fortherealitythattherearesignificantdifferencesincountry
riskexposuresacrosscompanies;export-orientedcompanies
inanemergingmarketmaybelessexposedtocountryrisk
thandomestic companies.Second, itallows usto notonly
incorporatecountryriskintothecostsofequityofdeveloped
market companies but to also consider risk exposures in
multiple countries. The third approach does require an
estimateofλ,andtherearethreewaystoobtainthevalue.