Aswath Damodaran flags rise in global risk premiums after U.S. treasury downgrade

Aswath Damodaran, the NYU professor whose valuation models are staples in corporate finance, has warned that country risk premiums are rising globally, driven in part by the downgrade of U.S. sovereign debt, an event that, he says, has forced a fundamental rethink of the traditional risk-free benchmark.

In his latest mid-year update published on July 31, Damodaran wrote that the U.S. Treasury downgrade by Moody’s in May 2025 — following earlier downgrades by S&P in 2011 and Fitch in 2023 — “has thrown a wrench into the process” of calculating the implied equity risk premium (ERP) for the S&P 500, which he uses as the starting point for estimating global equity risk.

Until this downgrade, Damodaran said he subtracted the 10-year U.S. Treasury yield directly from the expected return on the S&P 500 to derive the implied ERP. But the Aa1 rating now means that Treasury yields embed a default spread. “To remove that risk,” he said, “I net out the default spread associated with Aa1 rating from the treasury rate to arrive at a riskfree rate in dollars and an equity risk premium based on that.”

On June 30, the expected return on the S&P 500 stood at 8.45%. After adjusting the 10-year Treasury yield of 4.24% for a 0.27% default spread, Damodaran pegged the U.S. risk-free rate at 3.97%, resulting in a U.S. ERP of 4.48%.

India: Risk premium rises to 7.46%

In the India context, Damodaran estimated an equity risk premium of 7.46% for an average-risk investment denominated in Indian rupees as of July 1, 2025.

To arrive at this, he adjusted the Indian 10-year government bond yield of 6.32% by subtracting the country’s default spread of 2.16%, arriving at a rupee risk-free rate of 4.16%. Adding the India-specific ERP to this gave a total expected return of 11.62% on Indian equities.

“Note also that if using the Indian government bond rate as the riskfree rate in rupees, you would effectively be double counting Indian country risk, once in the government bond rate and once again in the equity risk premium,” Damodaran cautioned.

He added that for high-inflation currencies like the Indian rupee, analysts should ensure that discount rates and cash flow projections are inflation-aligned, or convert the entire valuation into U.S. dollars using differential inflation estimates.

Ripple effects on global country risk premiums

Damodaran said he adjusted the U.S. ERP further to derive a “mature market” premium of 4.21%, stripping out the default spread to reflect the risk premium for Aaa-rated countries like Canada, Australia, and most of Northern Europe. For all other countries, he computed additional country risk premiums based on sovereign default spreads, scaled up to reflect the greater volatility of equities, and added them to the base premium.

This adjustment has raised the equity risk premium for countries previously benchmarked against a risk-free U.S. Treasury rate. “The effects of the US ratings downgrade also manifest in the table, with the US now having a higher equity risk premium than its Aaa counterparts,” Damodaran noted.

Fragile sovereign ratings landscape

Damodaran also highlighted the broader decline in sovereign credit quality. In 2025, only 11 countries retained Aaa ratings, down from 15 a decade ago, with the UK and France among those downgraded. “The number of countries with sovereign ratings available on them has surged… but the number of Aaa rated countries has dropped,” he wrote.

He cautioned that sovereign ratings, while long-standing indicators of default risk, often lag reality and underrepresent political and social risks in several high-rated countries. For instance, “the Middle East… has high sovereign ratings” despite considerable geopolitical instability, he wrote.

To mitigate these limitations, Damodaran said he incorporates sovereign credit default swap (CDS) spreads, which reflect real-time investor sentiment, into his framework for assessing country risk. “These market-determined numbers will reflect events on the ground almost instantaneously, albeit with more volatility than ratings,” he said.

Corruption, violence, and legal fragility compound risk

Beyond credit risk, Damodaran underscored how non-financial factors, including corruption, exposure to violence, and legal unpredictability, shape country risk and feed into equity risk premiums. Using data from Transparency International, the Institute for Economics & Peace, and the Property Rights Alliance, he presented heat maps that closely mirrored his equity risk premium map.

“The parts of the world that are most exposed to corruption and violence, and have capricious legal systems, tend to have higher equity risk premiums,” Damodaran noted, reinforcing the link between qualitative risk factors and valuation discounts.

Country of operation, not incorporation, determines exposure

Importantly, Damodaran stressed that investors and analysts should focus on where a company operates, not where it is incorporated. “The exposure to country risk comes from where a company operates, not where it is incorporated,” he said. For multinationals, Damodaran recommended using revenue or production weights to blend risk premiums across countries.

In corporate finance decisions, he said, “the location of the project will determine which country’s equity risk premiums come into play.” For example, if Amazon invests in Brazil, it is the Brazilian ERP, not the U.S. ERP, that matters for cost-of-equity calculations.

Guidance for valuation practitioners

Damodaran closed the post with a detailed user guide on how to apply his ERP estimates in practice, from selecting the right currency and estimating risk-free rates, to aligning projected cash flows with the chosen inflation environment. For high-inflation markets like Turkey, he emphasized the importance of converting dollar returns using inflation differentials to arrive at realistic local-currency returns.

“There is nothing in this process that is original or path-breaking,” he said, “but it does yield a systematic and consistent process for estimating discount rates, the D in DCF.”

Still, he cautioned against misuse: “I worry about people using these premiums in their valuations, without understanding the choices and assumptions that I had to make to get to them.”

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