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

A firm's operations are in a country where the sovereign default spread is 4.0%. Which statement best describes the effect of using the sovereign default spread directly as the country equity risk premium, compared with scaling it by relative equity volatility?

Using the default spread alone typically understates the country equity risk premium. Equity markets are usually more volatile than the sovereign's bonds, so the volatility ratio exceeds one and scaling the spread raises the premium. The unscaled spread captures only bond default risk.

  1. AIt typically understates the equity risk premium because equities are riskier than the sovereign's bondsCorrect
  2. BIt typically overstates the premium because bonds are more volatile than equities
  3. CIt gives identical results whenever the default spread is positive
  4. DIt removes the need to estimate a mature market premium

Explanation

Equity is more volatile than the sovereign bond, so the ratio of equity to bond volatility usually exceeds 1. Scaling therefore raises the premium above the raw default spread. Using the spread alone understates equity country risk.

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