FRM Part I · FRM Exam Part I · Country Risk: Determinants, Measures, and Implications
Country Z has a sovereign default spread of 3.00%. The standard deviation of its equity market is 24% and the standard deviation of its USD-denominated government bond is 16%. Using the relative volatility approach, what is the country equity risk premium (ignoring the mature market premium)?
The country equity risk premium is 4.50%. The relative volatility approach scales the 3.00% default spread by the ratio of equity volatility to bond volatility, 24%/16% = 1.5, giving 3.00% x 1.5 = 4.50%.
- A2.00%
- B3.00%
- C4.50%Correct
- D5.33%
Explanation
Country equity risk premium = default spread x (equity volatility / bond volatility) = 3.00% x 24/16 = 3.00% x 1.5 = 4.50%. Using the inverse ratio (16/24) gives 2.00%, which is the key mistake. Using the spread alone ignores the extra equity risk.
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