FRM Part I · FRM Exam Part I · Country Risk: Determinants, Measures, and Implications
An analyst estimates the equity risk premium for a country by starting from a mature-market premium and adding a country risk premium (CRP) derived from sovereign default spreads. Which statement best describes the logic of the default-spread-based approach to the CRP?
The default-spread approach scales the sovereign default spread by the ratio of equity market volatility to government bond market volatility, because equities are riskier than the sovereign bond. The result is the country risk premium added to the mature-market premium.
- AThe CRP equals the sovereign default spread, which reflects only the country's credit risk and is added directly to the mature-market premium
- BThe CRP is the country's sovereign default spread scaled by the relative volatility of its equity market to its government bond marketCorrect
- CThe CRP is the difference between the country's equity market return and its government bond yield over the last year
- DThe CRP is obtained by subtracting the mature-market premium from the country's historical average equity return
Explanation
The relative-volatility refinement of the default-spread method multiplies the sovereign spread by the ratio of equity market volatility to bond market volatility, since equity is riskier than the sovereign bond. Adding the raw spread alone ignores this scaling, and the other options describe historical premium approaches.
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