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

A risk manager estimates a country risk premium using relative equity market volatility. The sovereign default spread is 4.0%. The standard deviation of the country's equity market is 30%, and the standard deviation of the country's sovereign bond is 20%. The mature-market equity risk premium is 5.0%. Using the ratio of equity to bond volatility to scale the default spread, what is the total equity risk premium for the country?

The total equity risk premium is 11.0%. The country risk premium is the 4.0% default spread scaled by the equity-to-bond volatility ratio of 1.5, giving 6.0%. Adding the 5.0% mature-market premium produces 11.0%. Using the unscaled spread would understate the premium at 9.0%.

  1. A11.0%Correct
  2. B9.0%
  3. C10.0%
  4. D6.0%

Explanation

Country risk premium = default spread x (equity volatility / bond volatility) = 4.0% x (30/20) = 6.0%. Total ERP = 5.0% + 6.0% = 11.0%. The 9.0% answer adds only the default spread (5% + 4%), omitting the volatility scaling. The 6.0% option reports only the country premium and omits the mature premium.

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