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

A country has a sovereign default spread of 3.0% based on its bond yield over a default-free benchmark. The annualized standard deviation of its equity market is 24% and that of its government bond market is 16%. Using the relative equity market volatility approach (default spread scaled by the ratio of equity to bond volatility), what is the country risk premium?

The country risk premium is 4.5%. The sovereign default spread of 3.0% is multiplied by the ratio of equity volatility to bond volatility, 24% divided by 16%, which is 1.5, giving 4.5%. This scales the bond-based spread up to reflect the greater risk of equities.

  1. A2.0%
  2. B4.5%Correct
  3. C3.0%
  4. D5.0%

Explanation

CRP = default spread × (σ equity / σ bond) = 3.0% × (24/16) = 3.0% × 1.5 = 4.5%. Using the inverse ratio (16/24) gives 2.0%, which is wrong. Using the spread alone ignores equities being more volatile than bonds.

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