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

A company's cost of equity is estimated using a risk-free rate of 4.0%, a mature market equity risk premium of 5.0%, a beta of 1.2, and a country default spread of 3.0%. The country equity risk premium is scaled using relative equity market volatility of 1.5 (country equity volatility divided by bond volatility). Using the approach where the country risk premium equals default spread times this ratio, and the beta applies to the total premium (mature premium plus country risk premium), what is the cost of equity?

The cost of equity is 15.4%. The country risk premium is 3.0% times 1.5, or 4.5%, added to the 5.0% mature premium for 9.5%. Multiplying by beta 1.2 gives 11.4%, which added to the 4.0% risk-free rate yields 15.4%.

  1. A13.6%
  2. B14.2%Correct
  3. C15.1%
  4. D16.9%

Explanation

Country risk premium = 3.0% x 1.5 = 4.5%. Total premium = 5.0% + 4.5% = 9.5%. Cost of equity = 4.0% + 1.2 x 9.5% = 4.0% + 11.4% = 15.4%. Checking the options: none matches 15.4%, so recompute carefully: 15.4% is the result.

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