Is making a country risk premium adjustment to the CAPM improving the CAPM?

The CAPM is the most used method in estimating a company’s cost of equity. However, several empirical studies show that this model is weak when applied to emerging countries. This paper studies if and how the CAPM explanatory power can be enhanced by adjusting the model for the country risk premium. We tested three different models with three different CRP estimation methodologies: sovereign spread, credit default swap spread and relative volatility. Model 1 assumes that each company has the same exposure to the country risk premium. Model 2 assumes that the country risk premium is a market risk and should be measured by the beta consequently. Model 3 assumes that every company has its own exposure to country risk, which is measured with a separate factor. We found that adjusting the CAPM for the country risk premium improves the CAPM explanatory power in model 2 and 3, with model 3 performing better compared to model 2. Moreover, the CRPs that mostly improve the CAPM are the sovereign spread and the credit default swap spread. A consequence of how the study is designed is that the exposure to the country risk premium varies from company to company, depending on its characteristics and not merely on the country’s development. Hence, this exposure should be measured by the beta or by a separate factor, without assuming equal exposure for every company.