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

An analyst building a discount rate for an investment in a emerging market uses the sovereign default spread approach. The mature-market equity risk premium is 5.0%, and the country's sovereign bond yield exceeds the risk-free rate by a default spread of 3.0%. Under this approach, the country risk premium is added to the mature-market premium. Which of the following correctly describes the total equity risk premium if the country risk premium is set equal to the default spread?

The total equity risk premium is 8.0%. When the country risk premium equals the sovereign default spread, it is simply added to the mature-market premium: 5.0% plus 3.0%. Ignoring the spread gives 5.0%, and subtracting it would be conceptually wrong.

  1. A8.0%Correct
  2. B5.0%
  3. C2.0%
  4. D15.0%

Explanation

Under the default spread approach with the premium set equal to the spread, total ERP = mature premium + default spread = 5.0% + 3.0% = 8.0%. Subtracting the spread gives 2.0%, which is the wrong sign. Using 5.0% ignores the country risk adjustment entirely.

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