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

A multinational analyst values a firm whose operations are entirely in an emerging market. The analyst discounts expected cash flows using a cost of equity that already includes a country risk premium, and then also reduces the expected cash flows to reflect the probability of expropriation. What is the main problem with this approach?

The approach double counts country risk. The country risk premium in the cost of equity already compensates for risks such as expropriation, so cutting the expected cash flows for the same risk again understates value. A risk should be reflected either in cash flows or in the discount rate, not both.

  1. AIt double counts country risk, because the same risk is captured in both the discount rate and the cash flowsCorrect
  2. BIt ignores country risk because expropriation is a diversifiable risk
  3. CIt understates value because country risk premiums apply only to debt
  4. DIt violates the rule that cash flows must be stated in the local currency

Explanation

If country risk is reflected in the discount rate through a premium, adjusting expected cash flows for the same event counts it twice and undervalues the firm. Analysts should put a given risk in either the cash flows or the discount rate, not both. The currency option is unrelated to the double counting.

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