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

A multinational is valuing a manufacturing project in an emerging market. The firm's analyst argues that because the country's political and economic risks are largely uncorrelated across countries, no country risk premium should be added to the discount rate for the project. Which statement best evaluates this view in the context of country risk research?

The view is only partly valid. Country risks across emerging markets are correlated with global market movements, particularly during crises, so some of this risk is systematic and cannot be diversified away. A premium may therefore be justified, though not necessarily the full sovereign spread.

  1. AIt is correct, because all country risk is diversifiable once a firm operates in multiple countries
  2. BIt is incorrect, because country risk is always fully non-diversifiable and must be added in full
  3. CIt is partly valid, but evidence shows country risk is correlated with global market movements, so some country risk is not diversifiable and may be pricedCorrect
  4. DIt is correct, because sovereign default spreads already capture all project-level risk

Explanation

Country risk exposures tend to move with global markets, especially in crises, so part of the risk is systematic. Saying it is entirely diversifiable ignores this correlation. Saying it is entirely non-diversifiable overstates the case, since some country-specific risk can be diversified away.

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