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

A portfolio manager notes that Country X is rated Baa2 by Moody's, while its ratings-based default spread is derived from the yield spread on dollar-denominated sovereign bonds in the same rating class. The manager wants a cost of equity for a company in Country X. Under the ratings-based approach, which step is the correct way to use the sovereign default spread?

The default spread should be scaled up by the ratio of equity market volatility to sovereign bond volatility, because equities are riskier than the country's bonds. The scaled result is the country equity risk premium added to the mature market premium.

  1. AAdd the default spread to the risk-free rate to estimate a country risk premium for equity directly with no adjustment
  2. BUse the default spread alone as the equity risk premium for all companies in the country
  3. CAdd the default spread to the mature market equity risk premium to obtain a total equity risk premium, ignoring equity volatility
  4. DScale the default spread by the ratio of equity market volatility to bond market volatility to obtain the country equity risk premiumCorrect

Explanation

Damodaran argues equities are riskier than sovereign bonds, so the default spread is multiplied by the relative standard deviation of the equity market to the bond market. The other options either use the spread unscaled or confuse it with a full equity premium.

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