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

A multinational firm is valuing a project in an emerging market. The analyst raises the discount rate by adding the sovereign default spread to the cost of debt and a country risk premium to the cost of equity. Which statement best describes the purpose of this adjustment?

The adjustment raises the required return so it reflects the extra risk of operating in a risky country. It is not a currency conversion, does not remove exchange rate risk, and cannot guarantee a positive NPV; it simply prices country risk into the discount rate.

  1. AIt compensates investors for the additional risk of operating in the country, reflected in the required returnCorrect
  2. BIt removes all exchange rate risk from the project cash flows
  3. CIt guarantees that the project's net present value will be positive
  4. DIt converts the project cash flows from local currency into the home currency

Explanation

Adding a country risk premium to the cost of equity and a default spread to the cost of debt raises required returns to reflect the extra risk of operating in the country. It does not eliminate currency risk, convert cash flows, or ensure a positive NPV. Currency conversion is a separate step.

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