Final answer:
The equity risk premium for a multinational company is calculated by considering exchange rate risks and leveraging purchasing power parity to account for economic diversity.
Step-by-step explanation:
To calculate the equity risk premium for a multinational company that operates in many different geographies, you need to consider the additional risks such companies face compared to domestic companies. These include exchange rate risk, which can lead to imbalances in trade and result in high inflows or outflows of financial capital, affecting the returns and inherent risk of investments in different countries. Also, factors such as purchasing power parity (PPP) must be taken into account, since it helps to convert and compare average incomes internationally, adjusting for differences in price levels across countries.
In practice, the risk premium is often derived by taking the expected return of the market and subtracting the risk-free rate. The challenge with multinationals lies in identifying appropriate market benchmarks and risk-free rates that reflect the diversity of economies in which the company operates. Strategies such as using a weighted average of country-specific equity risk premiums adjusted for PPP, or employing a global risk model that considers international dollars, can be used to cross-account for the geopolitical risks and diverse economic conditions.
Furthermore, the investment risk profile of an individual should evolve over their lifetime, with a higher risk tolerance typically being more suitable during the early stages of their career, while a more conservative approach may be advisable as one approaches retirement.