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

Which of the following is the most important limitation of estimating a country's equity risk premium from its historical equity returns relative to government bond returns?

The main limitation is that historical premium estimates carry large standard errors and are unreliable over short periods, which is typical of emerging markets with limited, volatile return histories. The other statements are not generally true.

  1. AHistorical premiums are always lower than implied premiums
  2. BEstimates have large standard errors and are unreliable for short periods, especially in emerging markets with limited dataCorrect
  3. CHistorical premiums cannot be computed for countries with sovereign ratings below investment grade
  4. DHistorical premiums ignore the mature-market premium entirely

Explanation

Historical premiums are noisy; the standard error is large relative to the estimate, and many emerging markets have short, volatile histories, making estimates unreliable. The other claims are not true as general statements.

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