FRM Exam Part I · Country Risk: Determinants, Measures, and Implications

Country Risk in Valuation and Cost of Capital

Updated 11 October 2026 · Fact-checked

Country risk is added to valuation by raising the cost of equity or by cutting expected cash flows. For the discount rate, use Re = Rf + β × ERP(mature) + β × CRP, or Rf + β × ERP + λ × CRP. Lambda measures a firm's exposure to country risk. Keep currency and inflation consistent across cash flows and rates.

Understand Country Risk in Valuation and Cost of Capital

A company in a risky country faces extra dangers: default by the government, currency crises, expropriation, political turmoil and capital controls. Investors want compensation. In valuation you can give it to them in two places: the discount rate or the expected cash flows. Never in both, or you double count.

The usual starting point is the country risk premium (CRP). It is the extra equity return demanded for investing in a country over a mature market such as the US. A common estimate scales the sovereign default spread by the relative volatility of equities to bonds: CRP = default spread × (σ equity ÷ σ bond). The default spread can come from a rating or from sovereign CDS or bond spreads.

The next question is how much of the CRP a given firm bears. There are three views:

Beta-scaled: every firm bears the CRP in proportion to its beta. Re = Rf + β × (ERP + CRP).
Flat: the CRP is not scaled by beta and is added as a flat amount. Re = Rf + β × ERP + CRP. This is the same as assuming λ = 1 for every firm in the lambda approach below.
Lambda: each firm has its own exposure λ to country risk. Re = Rf + β × ERP + λ × CRP.

In all three, ERP is the mature market equity risk premium.

Beta measures exposure to mature market risk. Lambda measures exposure to country-specific risk. They are different. An exporter earning dollars from a country has low lambda even though its beta may be normal. In this page, lambda is the relative measure: the firm's share of revenues from the country divided by the average firm's share. An average firm has lambda of 1. A firm with more of its revenue in the country than the average firm has lambda above 1. Some sources define lambda as the raw share of revenues from the country, so a fully domestic firm has lambda of 1. Check which definition a question gives. Lambda can also be estimated from the share of production, or from regression of the firm's returns on a country bond return. An average of these is common.

Currency and inflation must match. If cash flows are in local currency, discount at a local-currency rate. If they are in USD, use a USD rate. Convert between them using the inflation differential: (1 + local rate) = (1 + USD rate) × (1 + local inflation) ÷ (1 + USD inflation). Using a local-currency discount rate on USD cash flows, or the reverse, is a classic error.

Key formulas to remember

Country risk premium from default spread: CRP = Default spread × (σ equity ÷ σ government bond); Default spread is the sovereign yield over a default-free yield in the same currency. The ratio scales bond risk to equity risk.
Total equity risk premium: ERP(country) = ERP(mature) + CRP; Used when all firms are assumed to bear the full country risk.
Cost of equity, beta approach: Re = Rf + β × (ERP(mature) + CRP); CRP is scaled by beta. Assumes country risk exposure is proportional to beta.
Cost of equity, lambda approach: Re = Rf + β × ERP(mature) + λ × CRP; λ is the firm's exposure to country risk. Under the relative definition used here, an average firm has λ = 1 and a firm more exposed than average has λ above 1. Under the absolute definition (λ = % of revenues in the country), a firm with all its revenue in the country has λ = 1. Setting λ = 1 for every firm gives the flat view: Re = Rf + β × ERP + CRP.
Lambda from revenues: λ = (% revenues in country) ÷ (average % revenues in country for the typical firm); The relative measure, where an average firm has λ = 1. Other versions use the raw revenue share, production or regression. Check which definition the question gives.
Currency conversion of rates: (1 + r local) = (1 + r USD) × (1 + inflation local) ÷ (1 + inflation USD); Keeps the discount rate in the same currency as the cash flows.
Cost of capital: WACC = E/V × Re + D/V × Rd × (1 − t); The cost of debt should also include the country default spread.

How to solve Country Risk in Valuation and Cost of Capital questions

Use the same sequence for any question on country risk in valuation. Work out what the question gives you and which approach it wants.

1Identify the currency of the cash flows and decide which currency the discount rate must be in.
2Find the risk-free rate in that currency. Note whether it is already free of default risk.
3Compute or read the CRP. If only a default spread and volatilities are given, use CRP = spread × (σ equity ÷ σ bond).
4Pick the approach: beta-scaled CRP, flat CRP, or lambda. Follow the question's wording.
5Compute the cost of equity with the matching formula. Watch that beta multiplies only the mature ERP in the lambda approach.
6Adjust for debt if asked: add the country default spread to the cost of debt, then weight with WACC.
7If currency conversion is needed, use the inflation differential, not a spot rate.
8Check that country risk is in the discount rate or the cash flows, not both.

Quickest way: Plug-in check for the lambda formula

When to use it: Use this when the question gives β, ERP, CRP and λ and asks for cost of equity. It takes under a minute.

Write Re = Rf + β × ERP + λ × CRP and fill each number in.
Calculate the two risk pieces separately: β × ERP, then λ × CRP.
Add Rf and both pieces. Convert percentages carefully.
Sanity check: with λ = 1 and β = 1, the result should equal Rf + ERP + CRP. Under the relative definition, λ = 1 means average exposure. Eliminate options that break this logic.
If the question gives a firm's revenue share, divide by the average share to get λ first, unless the question defines λ as the raw share.

Common mistakes in Country Risk in Valuation and Cost of Capital

Multiplying the CRP by beta in the lambda approach
The beta-scaled formula is the most familiar one, so students apply it by habit.
Fix: In the lambda approach, beta multiplies only the mature ERP. Lambda multiplies the CRP.
Using the raw default spread as the CRP
The spread looks like a premium, so it seems ready to use.
Fix: Scale it by σ equity ÷ σ bond. Equity is riskier than the sovereign bond, so the CRP is larger than the spread.
Treating beta and lambda as the same thing
Both are exposure measures and both are multiplied by a premium.
Fix: Beta measures exposure to mature market risk. Lambda measures exposure to country risk. Their values can differ widely for the same firm.
Mixing currencies between cash flows and discount rate
Students take a local rate for convenience and apply it to USD forecasts.
Fix: Match the currency. Convert rates using the inflation differential if needed.
Double counting country risk
A student raises the discount rate and also cuts cash flows for the same risk, such as expropriation.
Fix: Choose one place. Use expected cash flows for specific, estimable events, and the discount rate for the general premium.
Ignoring country risk in the cost of debt
Focus stays on equity, where the CRP is shown.
Fix: Add the default spread to the cost of debt when computing WACC for a firm in a risky country.

Worked examples

Example 1

A firm operates in a country with a sovereign default spread of 3.0%. Equity volatility is 24% and the sovereign bond volatility is 16%. The risk-free rate is 4.0%, the mature ERP is 5.0%, the firm's beta is 1.2 and its λ is 0.8. Find the cost of equity using the lambda approach.

Show the solution

CRP = 3.0% × (24 ÷ 16) = 3.0% × 1.5 = 4.5%.
β × ERP = 1.2 × 5.0% = 6.0%.
λ × CRP = 0.8 × 4.5% = 3.6%.
Re = 4.0% + 6.0% + 3.6% = 13.6%.

Answer: Cost of equity = 13.6%.

Example 2

A project's cash flows are forecast in local currency. The USD discount rate is 10%. Expected local inflation is 8% and USD inflation is 2%. Find the local-currency discount rate.

Show the solution

Use (1 + r local) = (1 + r USD) × (1 + inflation local) ÷ (1 + inflation USD).
(1.10) × (1.08) ÷ (1.02) = 1.188 ÷ 1.02.
1.188 ÷ 1.02 = 1.16471.
r local = 16.47%.

Answer: The local-currency discount rate is about 16.47%.

Exam tips

Read whether the question asks for the beta approach or the lambda approach. The formulas look similar but give different answers.
If lambda is defined by revenues, divide the firm's share by the average share. Do not use the raw share unless told to.
Check the currency of every input before computing. Many wrong options come from currency mismatches.
Remember the CRP scaling by relative volatility. The raw spread is a frequent trap option.
Conceptual questions often ask why lambda differs from beta: it captures exposure to country risk, not market risk.

Practice questions from Country Risk: Determinants, Measures, and Implications

Country Risk in Valuation and Cost of Capital in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CS ExecutiveCost of Capital

Country Risk in Valuation and Cost of Capital: frequently asked questions

What is the difference between beta and lambda in country risk?

Beta measures a firm's sensitivity to mature market risk. Lambda measures its sensitivity to country-specific risk. Two firms in the same country can have the same beta but very different lambdas, for instance an exporter and a domestic retailer.

How do I adjust the discount rate for country risk?

Add a country risk premium to the cost of equity. In the lambda approach, Re = Rf + β × ERP(mature) + λ × CRP. You can also add the default spread to the cost of debt before computing WACC.

How is the country risk premium estimated?

A common method scales the sovereign default spread by the ratio of equity volatility to government bond volatility. The default spread can come from ratings or from sovereign CDS spreads.

Should I adjust cash flows or the discount rate for country risk?

Either can work, but not both for the same risk. Specific, estimable events such as expropriation can be modelled in the expected cash flows. General country risk is usually put in the discount rate.