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

An analyst estimates a country's equity risk premium (ERP) as the mature market ERP of 4.5% plus the country default spread scaled by relative equity market volatility. The country default spread from CDS is 2.0%. The annualized standard deviation of the country's equity index is 24% and that of its sovereign bond is 15%. The estimated country ERP is closest to:

The relative volatility is 24/15 = 1.6, so the country risk premium is 2.0% times 1.6 = 3.2%. Adding the 4.5% mature market premium gives a country equity risk premium of 7.7%. Omitting the volatility scaling would wrongly give 6.5%.

  1. A6.5%
  2. B7.7%Correct
  3. C8.2%
  4. D9.5%

Explanation

Scale factor = 24/15 = 1.6. Country risk premium = 2.0% x 1.6 = 3.2%. Total ERP = 4.5% + 3.2% = 7.7%. Adding the unscaled spread gives 6.5%, which ignores relative volatility.

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