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

A firm values a project in Country Z using a risk-free rate of 3.0%, a mature-market ERP of 5.0%, and a project beta of 1.2. Country Z's CRP is 4.0%. The analyst uses the approach in which the CRP is added to the ERP and multiplied by beta (CRP exposure equals beta). Separately, a colleague uses a lambda of 0.5 for the project's exposure to country risk, so the CRP is multiplied by lambda only. What are the two costs of equity, respectively?

The costs of equity are 13.8% and 11.0%. The beta approach gives 3% plus 1.2 times 9%, or 13.8%. The lambda approach gives 3% plus 1.2 times 5% plus 0.5 times 4%, which is 11.0%.

  1. A14.0% and 11.0%
  2. B13.8% and 11.0%Correct
  3. C13.8% and 10.4%
  4. D14.0% and 12.0%

Explanation

Beta approach: 3.0% + 1.2 × (5.0% + 4.0%) = 3.0% + 10.8% = 13.8%. Lambda approach: 3.0% + 1.2 × 5.0% + 0.5 × 4.0% = 3.0% + 6.0% + 2.0% = 11.0%. Option 14.0% mistakenly adds the CRP without beta scaling to the mature ERP in the first case.

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