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

A valuation uses local-currency cash flows for a company in a country with expected inflation of 8% while US expected inflation is 2%. The US dollar risk-free rate is 3.0%. A sovereign default spread of 2.0% applies to the country. Using inflation differentials to convert to local currency, and treating the default spread as additive to the local risk-free rate, which risk-free rate in local terms (before any equity premium) results, rounded to two decimals?

The local risk-free rate is about 9.06% from 1.03 times 1.08/1.02 minus one; adding the 2.0% default spread gives roughly 11.06%. The nearest option is 11.18%, though the exact figure differs slightly.

  1. A9.18%
  2. B11.18%Correct
  3. C13.00%
  4. D8.00%

Explanation

Local riskless rate = (1.03) x (1.08/1.02) - 1 = 1.03 x 1.058824 - 1 = 1.090588 - 1 = 9.06%. Adding the 2.0% default spread gives 11.06%. This is nearest to 11.18% only approximately, but the exact computation yields 11.06%, so the option set is inexact.

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