Nayan Kanaparthi | Founder, Strategist, AI Builder

US Downgrade Shifts the Baseline:

Moody’s historic downgrade of US sovereign debt from Aaa to Aa1 in May 2025 nudged down the “mature market” equity risk premium (ERP) anchor by 12 bps. However, India’s country risk premium (CRP) jumped by 32 bps in Aswath Damodaran . India’s total ERP thus rose to 7.46%, up from ~7.26% prior – an intriguing divergence where India’s risk pricing increased even as the global base fell.

Damodaran vs. Market-Implied ERP:

Damodaran’s latest table (post-downgrade) implies an India CRP of ~3.25% (up from 2.93%) on a base ERP of ~4.21%. We cross-check this with a Nifty 50-derived ERP. Using a forward earnings yield and growth approach (Gordon Growth), we estimate the implied cost of equity for Indian equities around 13–14% in INR terms. Subtracting the 10-year government bond yield (~6.3% as of July 31, 2025) suggests a market-implied ERP ~6.5–7.0%, roughly in line with Damodaran’s 7.46%. The convergence signals that investor expectations are catching up with fundamental risk metrics, though a slight gap persists.

Why India’s Country Risk Premium Rose?

India’s country risk premium (CRP) increased from 2.93 percent to approximately 3.25 percent in Damodaran’s July 2025 update. This rise happened despite the global baseline ERP moving lower after the US credit downgrade. The reason lies not in a change in India’s default risk, but in how equity volatility interacts with credit spreads inside Damodaran’s model.

At its core, CRP is calculated as:

For Baa3-rated countries like India, the default spread is estimated around 2.2 percent. Damodaran then adjusts this spread by multiplying it with a volatility ratio. In India’s case, equity markets have remained roughly 1.5 times as volatile as government bond markets. That puts the CRP at:

2.2%×1.5=3.3%

Which closely matches Damodaran’s reported 3.25 percent CRP for India.

The key insight here is that even if credit risk doesn’t worsen, a rise in equity volatility relative to bond volatility pushes up the premium. And in India’s case, that relative volatility did not decline.

Meanwhile, India’s 5-year CDS spread which reflects perceived default risk remained flat at approximately 84 basis points, both in January and July 2025. With no meaningful improvement in credit perception, the default spread remained unchanged. In other words, there was no justification for reducing India’s risk premium based on creditworthiness.

So although the US downgrade led to a “safety adjustment” in the global ERP anchor, India did not benefit from this shift. Its default risk held steady, and its equity market volatility stayed elevated. As a result, Damodaran’s model recalibrated India’s CRP upward.

Macro Fundamentals: High Growth, Low Per Capita

India’s economic footprint has expanded rapidly. By mid-2025, it reached a GDP of approximately 4.1 trillion dollars, making it the fourth-largest economy in the world. But this headline growth contrasts sharply with its per-capita GDP, which remains around 2,700 dollars. This disconnect between overall size and individual income is not just cosmetic, it has real implications for how investors perceive risk.

The World Bank’s 2024 report raised concerns that, if current trends continue, it could take India 75 years to reach even a quarter of U.S. per-capita income. This long horizon reflects classic symptoms of the middle-income trap, where economies grow rapidly in aggregate but fail to deliver broad-based improvements in living standards due to productivity stagnation, weak institutions, or labour-market rigidities.

Low per-capita income tends to signal weaker domestic purchasing power, less robust demand-side resilience, and greater vulnerability to external shocks. From a valuation standpoint, these factors increase uncertainty and may justify a structurally higher equity risk premium. Even when growth rates appear strong, the underlying sustainability of that growth becomes a key consideration for investors.

At the same time, the relatively low income base also offers room for catch-up growth, especially if India succeeds in unlocking productivity gains and implementing long-term reforms. How this tension plays out will continue to influence how India’s equity risk is priced in global portfolios.

Stable Rates, Lower Inflation

The year 2025 brought a much-needed macro stabilization for India. Headline CPI inflation fell into the Reserve Bank of India’s 4 percent target zone, largely driven by easing food prices. This gave the central bank the space to reduce interest rates. The repo rate, which had held steady at 6.50 percent through much of 2023 and 2024, was cut to 6.00 percent by April 2025.

As inflation moderated and policy softened, bond markets responded positively. The yield on India’s benchmark 10-year government bond fell by around 50 basis points, landing at 6.3 percent by mid-2025. This bond rally led to a significant tightening of India’s spread over US Treasuries. In fact, the India–US bond yield spread hit a 21-year low, which signals that global investors are increasingly comfortable with India’s macro stability and are demanding less of a premium to hold Indian debt.

Falling bond yields affect more than just fixed income markets. In valuation, the risk-free rate forms the base for discounting future cash flows. Lower yields should, in theory, reduce the cost of equity, pushing valuations higher. The total discount rate is:

Discount Rate= Risk-Free Rate + Equity Risk Premium (ERP)

So when India’s risk-free rate fell from about 6.8 percent to 6.3 percent, the expectation would be that the total return requirement for equities would drop, thereby supporting stronger valuations.

But that is not what played out in full. Damodaran’s model shows that while the risk-free rate dropped by 50 basis points, the equity risk premium went up from 7.26 percent to 7.46 percent. This increase in ERP offset the benefit of lower bond yields, leaving the total expected return on Indian equities still in the 13–14 percent range.

This dynamic explains why Indian equities did not re-rate as aggressively as some expected. The nominal risk-free rate is still elevated by global standards, and a 7 percent ERP on top of it keeps required returns in the low teens.

Even after a substantial drop in yields, the total cost of capital only fell by about 30 basis points. That is not enough to meaningfully reprice risk assets when ERP is rising in parallel. Despite all the positives , cooling inflation, lower interest rates, and improved yield credibility. Investors continue to price in structural risks and volatility under the surface.

Currency and CDS: Surprisingly Calm

Two of the most important real-time indicators of country-level financial risk are currency volatility and sovereign CDS spreads. These metrics are often the first to react when global markets become unstable. In 2025, however, both remained remarkably steady for India, despite broader geopolitical and macroeconomic turbulence.

1. Currency Risk: INR Stability

Foreign investors in Indian equities care about two returns. One is the return from the stock itself. The other is the currency-adjusted return once rupees are converted back to their home currency. If the rupee is unstable, that creates added uncertainty and risk, which leads investors to demand a higher premium.

But in 2025, the rupee stayed surprisingly stable. The USD/INR exchange rate held in a narrow range of 85 to 86 per dollar. After a brief spike in early May, where 1-month implied volatility in the FX market reached over 7 percent, volatility quickly cooled. By mid-year, it was back to 4.5 to 5 percent, which is low by emerging-market standards.

For comparison:

Brazil’s currency volatility often ranges from 8 to 10 percent
Turkey’s ranges from 15 to 20 percent

India’s FX curve also flattened, suggesting that the market expected calm to continue. This was a strong signal of investor confidence in India’s external position.

2. CDS Spread: Steady Credit Risk

Sovereign CDS spreads are like an insurance premium against a country defaulting on its debt. If spreads rise, investors believe that default risk is increasing. If they stay flat, it means perceived credit risk has not changed.

India’s 5-year CDS spread hovered at around 84 basis points throughout the first half of 2025. This was exactly where it stood at the start of the year. Importantly, this came even after the US credit downgrade by Moody’s — a moment that could have triggered contagion or risk repricing across emerging markets. But India’s CDS did not budge.

This indicates that investors continued to see Indian sovereign debt as stable and reliable. The fact that the CDS remained flat even when global benchmarks shifted is a quiet but powerful vote of confidence.

3. Supporting Macro Factors

India’s external position further reinforced this stability. By mid-2025, foreign exchange reserves stood at around 675 billion dollars, enough to cover 11 months of imports. That level of coverage provides a strong buffer against any currency crisis or external shock. It also reassures investors that the RBI has room to defend the rupee if needed.

So on paper, India’s macro and external risks were well-contained.

But Then, Why Didn’t the ERP Fall?

If both currency risk and credit risk were stable or improving, then logically, India’s equity risk premium should have decreased. But it didn’t. Instead, the ERP increased.

The reason lies within the equity market itself, not the macro indicators. Several structural factors continued to push equity-specific risk higher:

• High Valuations

Nifty 50’s price-to-earnings ratio frequently hovered between 22 to 24 times, which is above both global averages and India’s historical norms. When valuations are this rich, any earnings disappointment can trigger a correction. Investors know they are buying into a market that is already priced for perfection. That risk perception contributes to a higher ERP.

• Volatile Foreign Portfolio Inflows

While foreign investors poured capital into Indian equities, those flows remained highly sensitive to US interest rate changes. If US yields rise, capital often flows out of India and back into the US. These inflows and outflows create short-term volatility, which gets priced into ERP models.

• Earnings Concentration

A small number of companies such as Reliance, TCS, HDFC, and Infosys, account for a significant portion of the Nifty 50’s earnings weight. This creates idiosyncratic risk. If even one or two of these firms underperform, the broader index can be dragged down. That dependency keeps the ERP elevated, even if macro conditions are favorable.

India may have appeared more stable on the surface in 2025, but investors were still pricing in risk under the hood. It was not about inflation or currency volatility. It was about the structure and behavior of the equity market itself.

Policy and Sentiment: Risk Signals from Reform and Politics

India’s equity risk profile is shaped not only by macroeconomic metrics and financial volatility but also by the political and policy landscape. In 2025, several developments in governance, industrial strategy, and trade policy have influenced how investors perceive long-term stability and structural risk.

1. General Elections: Political Continuity

India held its general elections in the spring of 2024. The incumbent government retained power, which helped remove a layer of political uncertainty that can often disrupt markets. This continuity in leadership allowed ongoing policy programs to proceed without interruption and provided investors with greater clarity on the country’s economic direction. That said, the lead-up to the election season brought short-term volatility, as is typical in large democracies. Now, with the outcome behind, markets have recalibrated around a known policy trajectory.

2. Manufacturing Push: Production-Linked Incentive Schemes (PLI)

India’s ambitious Production-Linked Incentive (PLI) schemes have emerged as a key pillar in its effort to become a global manufacturing hub. These programs span multiple sectors from electronics and pharmaceuticals to automotive and textiles and are designed to attract foreign direct investment while boosting domestic output.

So far, early signs are promising. Sectors like smartphone assembly have seen rapid expansion, aided by the China-plus-one trend, which has driven global firms to diversify away from single-country supply chains. If these initiatives continue gaining traction, they could support long-term export growth, economic diversification, and job creation, all of which improve India’s equity risk profile. However, execution risk remains a concern. The true impact of PLI will depend on timely disbursals, ease of doing business, and coordination across states.

3. Trade Policy: Openness Versus Protectionism

India is actively negotiating trade agreements, including discussions with the United States to reduce tariffs in key sectors such as agriculture and automobiles. These efforts signal a broader intent to position India as a globally competitive economy.

At the same time, India has strategically used import tariffs in recent years to protect and grow domestic industries. This balancing act between openness and protectionism presents a mixed picture. On one hand, lower tariffs and deeper integration into global trade could compress India’s country risk premium by reducing external friction and encouraging capital inflows. On the other hand, if trade tensions rise or protectionist tendencies dominate, investors may assign a higher risk premium due to policy unpredictability.

4. Global Reshoring and FDI Momentum

Beyond policy design, global sentiment is shifting in India’s favor. Amid geopolitical tensions and supply chain realignments, India has emerged as a preferred alternative manufacturing base across sectors like semiconductors, electronics, and textiles. Foreign direct investment remained strong throughout 2024 and into 2025, reinforcing India’s appeal as a resilient and scalable market.

These trends could lead to greater investor participation over time, deeper liquidity in equity markets, and ultimately, reduced volatility. If capital flows remain consistent and institutional reforms continue, the structural risk perceived by investors may decline further.

Why India’s CRP Defied the US Anchor Drop?

One of the more surprising results in Damodaran’s mid-2025 update was that India’s country risk premium (CRP) rose by approximately 32 basis points, even though the global ERP anchor shifted downward after the United States lost its Aaa credit rating.

This can be explained by how the volatility-adjusted model reacts when the anchor drops. Prior to the downgrade, the US was treated as a fully risk-free market, and the base equity risk premium for mature markets was set at 4.33 percent. After Moody’s downgrade, Damodaran revised this base down to 4.21 percent, using Aaa-rated markets such as Germany and Switzerland as the new benchmark for low-risk status.

That 12-basis-point drop in the base ERP may seem small, but its effect compounds for emerging markets like India. Once the base is lowered, any country-specific risk layered on top becomes a larger proportion of the total required return.

In Damodaran’s framework, the CRP is calculated by multiplying a country’s default spread by a volatility adjustment factor, which reflects how volatile equity returns are relative to bond returns. For India, the volatility multiplier was substantial. India’s 10-year equity index volatility is estimated around 15 percent annualized, while local government bonds exhibit around 7 to 10 percent volatility. This yields a volatility ratio of 1.5 times or higher.

India’s default spread, proxied by a 5-year CDS level around 84 basis points, did not improve meaningfully during this period. In fact, with the US downgrade introducing a 0.40 percent default premium into the so-called “risk-free” US yield, all country risk spreads effectively had a new floor. India’s CDS spread staying flat meant that its credit risk remained unchanged, while the benchmark it was compared against became riskier. This created a relative effect: India did not become more risky, but it also did not improve enough to offset the impact of the shifting baseline.

As a result, the volatility-adjusted country premium added to India’s ERP rose, even though the starting point (the base ERP) had dropped. In other words, the model produced a higher CRP as a percentage of the total, because India’s metrics remained stable in a world where the comparison point moved.

This dynamic helps explain why India’s total ERP increased to 7.46 percent, even when global macro conditions and rates were stabilizing. The model did not punish India for getting worse, it highlighted that India had not improved in a relative sense, and therefore its risk premium grew in proportional terms.

Model vs. Market: Convergence or Divergence?

One of the most valuable checks on any model is how closely it aligns with real-world behavior. When it comes to India’s equity risk premium (ERP), the numbers from Damodaran’s framework and those implied directly from market data are surprisingly close.

Damodaran’s July 2025 estimate puts India’s total ERP at 7.46 percent, based on a 4.21 percent mature market baseline and a country risk premium of 3.25 percent. On the other hand, when we calculate a market-implied ERP using Nifty 50 data through a forward earnings yield approach, adjusted for long-term nominal growth and subtracting the 10-year government bond yield the result lands between 6.5 and 7.0 percent.

This tight band of alignment invites two interpretations.

1. The Model Might Be Slightly Conservative

Damodaran’s approach adjusts for country risk by multiplying sovereign credit spreads with a volatility ratio. This is meant to reflect how volatile a country’s equity market is compared to its bond market. While this is methodologically sound, it can be blunt at times, especially for a market like India’s where large-cap equities have shown relative stability in recent years.

From 2023 to 2025, India benefited from steady foreign institutional inflows and robust domestic SIP participation, both of which helped to dampen volatility in the equity market. If the model uses a generic emerging-market volatility multiplier, it could slightly overstate India’s current equity-specific risk.

2. The Market May Be Slightly Under-pricing Risk

On the flip side, it is also possible that the market is under-pricing some underlying structural risks. With global liquidity still relatively abundant and investor sentiment toward India positive, the market may be accepting lower returns than the country’s risk fundamentals would typically require. This could reflect confidence, or simply short-term exuberance.

The Safer Interpretation: Rough Equilibrium

Given that the gap is only a few basis points, the most reasonable conclusion is that market pricing and model projections are broadly aligned. India’s ERP is not being misjudged. Instead, both the model and the market are converging toward a shared understanding of risk.

Supporting this idea is a Grant Thornton analysis from late 2024, which found that the expected equity return for India was approximately 13.8 percent. With the 10-year bond yield at the time around 6.8 percent, this implied an ERP of 7.0 percent, almost exactly matching the upper bound of the market-implied estimate. As bond yields fell to 6.3 percent in 2025, the implied ERP nudged higher, closing the gap with Damodaran’s figure even more closely.

This convergence matters. It shows that investors and models are beginning to see risk the same way. India’s ERP remains high, but not in a way that suggests confusion or mispricing. Instead, it reflects mature recognition of both the upside and the uncertainty that define India’s evolving equity story.

Some models such as the Gordon Growth method imply a lower ERP of ~6.2% based on dividend and earnings growth forecasts, suggesting a gap of over 1% from Damodaran’s ERP. This difference stems from assumptions around forward growth, payout ratios, and risk-free benchmarks. The divergence reflects a real tension between market optimism and structural caution. A dynamic worth monitoring in a fast-changing macro environment.

Does Low Per-Capita Income Warrant a Higher Risk Premium?

India’s total GDP is now among the largest in the world. But when investors think about risk, they don’t just look at the size of an economy, they also consider ## how that wealth is distributed and how consistently it supports long-term growth

. This is where per-capita income becomes a critical lens.

As of 2025, India’s per-capita GDP is around 2,700 dollars, placing it approximately 129th in the world. That ranking matters because it signals more than just income levels. It often reflects deeper developmental issues, including infrastructure constraints, uneven skill development, and lower economic resilience during global shocks.

From a valuation perspective, these structural challenges can make corporate earnings less predictable. Even if the economy grows rapidly in aggregate terms, the benefits may not trickle down evenly or translate into consistent cash flow growth for businesses. This justifies a higher equity risk premium in the eyes of global investors.

The concept of the middle-income trap adds another layer to this logic. Many emerging economies have grown quickly from low income to middle income, only to plateau without making the leap to high-income status. That stagnation is often driven by productivity ceilings, policy bottlenecks, or institutional limitations. Investors may price in the possibility that a country like India, despite its momentum, could follow the same path.

That said, India’s case is not one-dimensional. The country is growing at 6 to 7 percent real GDP, it has a large and young working-age population, and its digital infrastructure is advancing rapidly. If reforms continue, India has a plausible shot at avoiding the trap that has held back many others.

The risk premium here reflects uncertainty, not inevitability. If investors begin to believe that India will successfully move beyond the five to eight thousand dollar per-capita range and head toward upper-middle income, that confidence will gradually translate into a lower CRP. This would reflect reduced structural risk and more predictable earnings potential.

On the other hand, if future data suggests that growth is jobless, or that inequality is rising and wage gains are concentrated, investor scepticism will remain. In that case, the risk premium will stay elevated, not because of market volatility, but because of long-term concerns about growth quality and inclusion.

Catalysts to Compress or Inflate India’s Country Risk Premium

India’s country risk premium (CRP) currently sits at around 3.25 percent in Damodaran’s latest model. This number is not static. It moves with both global dynamics and domestic fundamentals. The next phase of India’s equity story could see the CRP either compress back toward 3 percent or inflate beyond 3.5 percent, depending on how key catalysts unfold.

What Could Bring the CRP Down?

1. Credit Rating Upgrade

India is currently rated at the lowest investment-grade level (Baa3/BBB-). If Moody’s or another agency upgrades India to Baa2 or better, the default spread would fall, which would reduce the CRP. For instance, countries rated Baa2 often have default spreads around 1.5 percent. If India’s volatility multiplier stays in the 1.3 to 1.5 range, that would translate into a CRP closer to 2.0 percent, down from the current 3.25.

2. Continued Macro Stability

If India sustains low inflation, moderate fiscal deficits, and a stable rupee, that macro consistency helps lower perceived risk. Investors assign less of a risk buffer when they trust a country’s ability to manage its economy predictably, even during global stress periods.

3. Deeper Financial Markets

India’s domestic capital markets are expanding, but they are still maturing. As equity participation broadens, and liquidity improves, especially through sustained retail SIP flows and stronger institutional depth, short-term volatility in the equity market can decline. This would naturally reduce the volatility ratio that feeds into CRP models.

4. Payoff from Structural Reforms

If long-term initiatives such as the Production-Linked Incentive (PLI) schemes, infrastructure investments, and digital public goods begin delivering consistent productivity gains without triggering macro imbalances, it can signal stronger potential growth. When investors see that growth as predictable and well-managed, the required risk premium compresses.

What Could Push the CRP Higher?

1. Global Risk-Off Episodes

Events like a sharp tightening cycle by the US Federal Reserve or a global recession tend to hurt emerging market equities disproportionately. In those environments, investors demand more compensation for taking country-specific risk, and equity risk premiums widen.

2. Domestic Political or Policy Shocks

A surprise outcome in a major election, or a sudden shift away from business-friendly policy, could trigger uncertainty in the investment environment. This policy risk would show up almost immediately in CRP estimates, especially if capital flows turn volatile.

3. Geopolitical Events

India’s location means that border tensions or external conflicts are always priced into some extent of risk. A serious military escalation or a trade-related confrontation, especially with key partners could lead to a swift upward revision in country risk perception. The same applies to hypothetical situations like sanctions on oil imports or export bans in strategic sectors.

4. Macro Slippage

If inflation re-accelerates or fiscal conditions deteriorate significantly. Say, through a sharp increase in debt-to-GDP ratios or a widening current account deficit, India’s macro credibility could take a hit. These kinds of developments nearly always prompt investors to raise the discount they apply, which lifts the CRP.

In short, India’s risk premium is a function of confidence. If the country continues to show it can deliver long-term growth with macro stability and institutional strength, the premium will compress. If any of those pillars weaken due to internal missteps or external shocks, the premium will climb. Investors reward resilience and punish uncertainty. How India navigates this balance in the years ahead will determine how its equity risk is priced globally.

Conclusion: India’s Equity Risk Premium in Context

India’s equity risk premium (ERP) remains elevated, but it reflects a balanced view of both progress and risk. The 2025 downgrade of the United States credit rating was a revealing moment. Instead of triggering a drop in India’s risk premium, it highlighted India’s own position in the global risk hierarchy. Damodaran’s model recalibration assigned India a higher ERP, and market-based estimates closely mirrored that outcome. This confirms that investors continue to see India as riskier than developed markets, but not without reason.

This premium is not arbitrary. It captures the ongoing tug-of-war between India’s improving fundamentals and its remaining vulnerabilities. On one side are stable inflation, consistent GDP growth, a growing retail investor base, and structural reforms in sectors like manufacturing and infrastructure. On the other side are lower per-capita income, policy unpredictability, capital flow sensitivity, and geopolitical exposure.

The result is an ERP around 7 percent, which is significantly higher than the 4 to 5 percent expected in mature markets. That spread represents the reward investors demand for accepting India’s risk. But it also represents the opportunity. If India sustains its growth, deepens reform, and avoids the middle-income trap, the country risk premium could decline over time. That would reduce the required return and push equity valuations higher. In valuation terms, a falling ERP is the tide that lifts all boats.

On the other hand, if macro or political risks materialize, or if reform momentum weakens, India’s ERP could stay high or increase further. That would act as a headwind for equity pricing, even if earnings growth remains strong.

India today is a higher-risk, higher-reward market. The US downgrade reminded the world that even the most trusted anchors can shift. For India, the long-term challenge is to become one of those anchors, a market trusted not only for its growth potential, but for its stability and resilience.

Investor Signals to Watch: What Really Moves the ERP

Throughout this article, we looked at a wide range of factors that could influence India’s equity risk premium. But in practice, not every factor carries equal weight. Some metrics, like lower inflation and a stronger rupee, should have reduced India’s risk premium, but had little effect. Others, like unchanged CDS spreads or high equity volatility, continued to exert upward pressure.

For investors seeking to understand what will truly drive changes in ERP and when Indian equity valuations might re-rate, these are the metrics to focus on:

Sovereign CDS spreads, which reflect real-time credit risk
Equity versus bond volatility, which directly affects model-based CRP estimates
India’s sovereign credit rating, which shapes default spread assumptions
Inflation and fiscal discipline, which affect perceived macro credibility
Foreign portfolio flows and capital market depth, which influence volatility and investor confidence
Policy continuity and structural reform momentum, especially in trade, infrastructure, and manufacturing

The ERP is not a static number. It evolves with how investors interpret these signals. Watching the right ones and understanding which are already priced in is essential for anyone making long-term allocation decisions in Indian equities.

-- Nayan Kanaparthi