The country-spread approach for estimating the cost of equity in an emerging market uses the U.S. risk-free rate and the market risk premium for a U.S. index but makes two country-specific adjustments to the CAPM. Also, it has some major theoretical problems. Which of the following statements about this approach is correct?
A) It adds a country risk premium to the CAPM estimate that is calculated as the spread between U.S. dollar bonds issued by the foreign country's government and the required return on U.S. Treasury bonds.
B) It likely overstates the true cost of equity for an average firm in the foreign country because it "double counts" country risk factors in the two adjustments and it ignores other risks that might be relevant such as liquidity.
C) It adjusts the beta to reflect that the market return variance (or standard deviation) is likely to be different than the equivalent number for the U.S. market.
D) All of the statements above are correct.
E) All of the statements above are incorrect.

Question

Quizplus · Accepted Answer

The country-spread approach indeed adds a country risk premium to the CAPM estimate, likely overstates the true cost of equity due to potential double counting of country risk, and adjusts the beta to reflect differences in market return variance between the U.S. and the foreign market.

The Country-Spread Approach for Estimating the Cost of Equity in an Emerging