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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 an emerging market using the sovereign default spread approach. The mature-market equity risk premium is 5.0%. The country's government bond, denominated in US dollars, yields 7.5% while the US Treasury bond of the same maturity yields 4.0%. What is the country default spread that this approach uses as the starting point for the country risk premium?

The default spread is 3.5%, found by subtracting the US Treasury yield of 4.0% from the country's dollar-denominated bond yield of 7.5%. Both bonds are in the same currency, so the difference isolates compensation for sovereign default risk, which is the starting point for a country risk premium.

  1. A3.5%Correct
  2. B4.0%
  3. C7.5%
  4. D11.5%

Explanation

The default spread is the yield on the dollar-denominated sovereign bond minus the risk-free yield on the same-currency, same-maturity Treasury: 7.5% - 4.0% = 3.5%. Adding the yields (11.5%) or using one yield alone confuses the spread with a level of rates.

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