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

An analyst estimates the cost of equity for a firm operating in an emerging market using a mature-market equity risk premium plus an additional country risk premium (CRP). Which statement best describes the purpose of the CRP in this approach?

The country risk premium compensates investors for the additional risk of investing in a particular country, such as sovereign default and political risk, beyond what is in the mature-market equity risk premium. It is added to that premium and is not a beta, inflation, or diversifiable-risk adjustment.

  1. AIt compensates investors for exposure to the additional default and political risk of the country that is not captured in the mature-market premiumCorrect
  2. BIt replaces the risk-free rate with a rate that reflects the local inflation differential
  3. CIt adjusts the firm's beta so that it reflects the volatility of the global equity index
  4. DIt removes diversifiable firm-specific risk from the expected return

Explanation

The CRP is added to the mature-market equity risk premium to reflect extra risk of investing in a country, such as sovereign default and political risk. It does not change the risk-free rate or beta, and it is not about firm-specific diversifiable risk, which is not priced.

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