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

A firm values an Indonesian subsidiary. The mature-market equity risk premium is 5.0%, the sovereign default spread is 3.0%, and the ratio of equity market volatility to sovereign bond volatility is 1.5. The risk-free rate is 4.0% and the subsidiary's beta is 1.2. Using the approach that scales the default spread by relative volatility to obtain the country risk premium, and applying the beta to both the mature premium and the CRP, 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 it gives 9.5%, multiplied by beta of 1.2 is 11.4%, plus the 4.0% risk-free rate yields 15.4%.

  1. A10.0%
  2. B15.4%Correct
  3. C14.4%
  4. D12.0%

Explanation

CRP = 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%. Option 14.4% applies beta only to the mature premium and adds the CRP unscaled... wait, that gives 4+6+4.5=14.5; 14.4% arises from a miscalculation and is wrong. 10.0% omits the CRP.

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