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

An analyst computes a country equity risk premium as the sovereign default spread multiplied by the ratio of equity market volatility to sovereign bond volatility. Country Y's sovereign bond spread is 3.0%, its equity index has annualized volatility of 24%, and its government bond has annualized volatility of 16%. A mature market premium is 5.0%. A firm with a beta of 1.0 has a risk-free rate of 2.0%, and the country premium is added to the mature market premium. What is its cost of equity?

The cost of equity is 11.5%. The country premium is the 3.0% spread times the volatility ratio of 1.5, giving 4.5%. Adding that to the 5.0% mature premium yields 9.5%, and adding the 2.0% risk-free rate gives 11.5%. Using the raw spread would understate it.

  1. A11.5%Correct
  2. B9.0%
  3. C10.0%
  4. D12.5%

Explanation

Country risk premium = 3.0% x (24/16) = 3.0% x 1.5 = 4.5%. Cost of equity = 2.0% + 1.0 x (5.0% + 4.5%) = 11.5%. Using only the default spread (3.0%) gives 10.0%; omitting the country premium gives 7.0%; 9.0% results from inverting nothing meaningful.

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