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

A firm values an overseas project with cash flows in local currency (LC) growing at inflation. Inflation is 8% in the country versus 2% in the US. The spot rate is 20 LC per USD. The project's USD discount rate is 10%. Which approach to valuation is internally consistent?

Discount the local currency flows at a local-currency rate adjusted for the inflation differential, roughly 1.10 x 1.08/1.02 - 1, about 16.5%, then convert the present value at spot. This keeps currency and discount rate consistent; using the 10% USD rate on local flows would overvalue the project.

  1. ADiscount LC cash flows at 10% and convert the present value at spot
  2. BConvert LC cash flows at spot and discount at 10%
  3. CDiscount LC cash flows at about 16.2% and convert the present value at spotCorrect
  4. DDiscount LC cash flows at about 3.7% and convert at spot

Explanation

LC discount rate = 1.10 x (1.08/1.02) - 1 = 1.10 x 1.0588 - 1 = 16.47%, approximately 16.5%. Option 16.2% is the closest consistent figure to the inflation-differential adjustment. Using 10% on LC flows ignores inflation, and converting at constant spot ignores expected depreciation.

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