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

When valuing a multinational with operations across several countries, which approach to country risk is most consistent with the view that country risk is at least partly diversifiable and should be reflected in the firm's cost of equity according to the firm's operational exposure?

The best approach is to compute a weighted average country risk premium using the firm's revenue or production exposure across countries. This ties the premium to where the firm actually operates rather than where it is incorporated or what the home sovereign rating implies.

  1. AApplying the home-country risk premium to all of the firm's cash flows based on its country of incorporation
  2. BEstimating a weighted average country risk premium using the firm's revenue or production exposure across countriesCorrect
  3. CIgnoring country risk in the discount rate and adjusting only the risk-free rate
  4. DUsing the sovereign credit rating of the country of incorporation to set a single discount rate

Explanation

Operational exposure approaches weight country risk premiums by where revenues, production or other activities occur, rather than where the firm is incorporated. Incorporation-based approaches ignore actual exposure. Changing only the risk-free rate does not capture equity-specific country risk.

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