The market risk premium and the country risk premium

In short

• The MRP is the extra return expected on a broad, diversified stock index over a government security of the same country. With $r_f$, it sets the required return of an average-risk (beta 1.0) stock.
• CRP = sovereign yield spread (in a reserve currency such as USD or EUR) × $\sigma_{equity}/\sigma_{bond}$ of that country; then $E(r_i) = r_f + \beta_i(MRP_{developed} + CRP)$.
• Historical MRP: average index return minus average government return. Geometric averages give a smaller MRP than arithmetic; long-term bonds give a smaller MRP than bills. Equity valuation should generally use long-term government securities.
• Implied (forward-looking) MRP: $E(r_m) = Div_{1,m}/P_{0,m} + g$, minus the current government rate. Remember to grow this year's dividend into next year's.
• Developed-market MRPs are roughly 3%–6%; developing markets can be high single or double digits. Rising markets push historical MRPs up but implied MRPs down.