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

A multinational is valuing a subsidiary in an emerging market using a USD discounted cash flow model. A analyst proposes adding the country's sovereign default spread to the discount rate while the cash flows already include a probability-weighted haircut for expropriation and war losses. Which is the most accurate assessment?

The approach double counts country risk. Country risk can be reflected either by haircutting expected cash flows for losses such as expropriation or war, or by raising the discount rate with a country premium, but applying both for the same risk overstates the penalty and understates value.

  1. AThis is acceptable because country risk should always be counted in both numerator and denominator
  2. BThis double counts country risk; it should be reflected in either the cash flows or the discount rate, not bothCorrect
  3. CThis understates risk because the sovereign spread only captures currency risk
  4. DThis is correct only if the subsidiary exports all of its output

Explanation

Country risk adjustments can be placed in expected cash flows (scenario or probability weighting) or in the discount rate (a country risk premium). Doing both for the same risk penalizes value twice. The first option endorses that double counting.

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