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

Which approach to incorporating country risk into the valuation of a firm operating in a high-risk country is most consistent with the view that country risk is partly diversifiable and exposure differs across companies?

Scaling the country risk premium by a firm-specific exposure measure, such as the share of revenues earned in the country, is the best approach. It recognizes that firms differ in how exposed they are to country risk, unlike adding the same premium to every firm.

  1. ASetting the discount rate equal to the sovereign bond yield for all firms
  2. BAdding the full country risk premium equally to every firm's cost of equity
  3. CScaling the country risk premium by a firm-specific exposure measure, such as the share of revenues from the countryCorrect
  4. DIgnoring country risk entirely because investors hold global portfolios

Explanation

Exposure-based methods, such as a lambda tied to revenue share, assign different country risk to firms with different operations. A uniform addition ignores differing exposure, using the sovereign yield mixes default risk with equity risk, and ignoring it entirely overlooks non-diversifiable country risk.

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