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

An analyst estimates the equity risk premium for a country by scaling its sovereign default spread. The sovereign bond spread over the US Treasury is 3.0%. The standard deviation of the country's equity market is 24% and the standard deviation of its sovereign bond market is 16%. Using the relative equity market volatility approach, what is the country risk premium for equity?

The country risk premium is 4.5%. It equals the 3.0% sovereign default spread multiplied by the ratio of equity volatility to sovereign bond volatility, 24% divided by 16%, which is 1.5. This scales the bond-based spread up to reflect equity's greater risk.

  1. A2.0%
  2. B3.0%
  3. C4.5%Correct
  4. D5.0%

Explanation

Country risk premium = default spread × (equity volatility / bond volatility) = 3.0% × (24/16) = 3.0% × 1.5 = 4.5%. Using the spread alone (3.0%) ignores the higher risk of equity. Inverting the ratio gives 2.0%.

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