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

A country has a sovereign default spread of 3.00%. The volatility of its equity market is 24% and the volatility of its sovereign US-dollar bond is 16%. The mature-market equity risk premium is 5.00%. Using the relative equity market volatility approach (scaling the default spread by the ratio of equity to bond volatility), what is the total equity risk premium for the country?

The total equity risk premium is 9.50%. The country risk premium equals the 3.00% default spread multiplied by the volatility ratio 24/16, which is 4.50%. Adding this to the mature-market premium of 5.00% gives 9.50%.

  1. A9.50%Correct
  2. B8.00%
  3. C7.50%
  4. D12.50%

Explanation

Country risk premium = default spread x (equity vol / bond vol) = 3.00% x (24/16) = 4.50%. Total ERP = 5.00% + 4.50% = 9.50%. Option 7.50% would use the ratio inversely (3% x 16/24 = 2%, giving 7.00%) or omit the scaling; 8.00% simply adds the spread.

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