Skip to content

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

A valuation of a Mexican subsidiary is done in Mexican pesos. Expected peso cash flows are discounted at a USD-based cost of capital of 9.0% with no adjustment for currency. Expected long-run inflation is 4.0% in Mexico and 2.0% in the US. Which statement is correct about the consistent treatment?

Peso cash flows should be discounted at roughly 11%, because the USD rate of 9.0% must be adjusted upward for the 2-point inflation differential between Mexico and the US. Cash flows and discount rates have to be in the same currency, so leaving the USD rate unchanged is inconsistent.

  1. AThe peso cash flows should be discounted at approximately 11.0%, adjusting the USD rate for the inflation differentialCorrect
  2. BThe USD rate is acceptable because inflation affects only cash flows, not discount rates
  3. CThe discount rate should be reduced to about 7.0% because Mexican inflation is higher
  4. DThe rate should be left at 9.0% as long as a country risk premium is added to cash flows

Explanation

Cash flows and discount rates must use the same currency. Converting a USD rate to pesos: (1.09)×(1.04/1.02) − 1 ≈ 11.14%, roughly 11%. Lowering the rate for higher inflation reverses the adjustment.

Did you get it right without looking?

One question tells you little. A timed set on Country Risk: Determinants, Measures, and Implications shows your real accuracy, how long you take and where you lose marks.

Practise Country Risk: Determinants, Measures, and ImplicationsFree diagnostic mock

More Country Risk: Determinants, Measures, and Implications questions