Question

Question-3: Arundel Partners are contemplating an investment in Argentina. They gather data to determine the appropriate return to their equity investors. Their data suggest that Argentine equity market is 2.5 times more volatile than the US equity market; they estimate the project beta as 1.5, and the project has 100% exposure to Argentina country risk. Arundel partners assume that US risk-free rate is 3% and US EMRP is 5.5%. Given the volatility of the Peso and difficulty of hedging peso cash flows, Arundel partners think that a 3% additional currency risk premium (ie. Measure of Currency Risk x Unit Price of Currency Risk) is warranted on top of the Country Risk Premium. A. What is the Estimate CRP for Argentina based in relative equity market volatility? B. What should be the required rate of return Arundel shareholders expect in USD terms assuming 100% country risk exposure. C. What should be the required rate of return if the country risk were scaled the same as the market risk of the asset? D. If the Argentine credit default risk premium is 400 bp and equity market volatility to bond market volatility ratio is 1.4, what should be the Argentina Country Risk Premium?

Hint: Review the Nextel Peru case

Answer 1

US Equity market risk premium (EMRP) = 5.5%;

As Argentina equity market is 2.5 times volatile than US and Currency risk for Peso = 3%

A. hence Argentina country risk premium (EMRP) = 2.5 * 5.5% + 3%= 13.75% +3% = 16.75%

B. Required return assuming 100% country risk (US) exposure : 11.25%

Here we are assuming 100% exposure to US, the country in which Arundel Partners are based.

Risk free rate in US = 3%;  Project Beta = 1.5

Required return (Cost of equity) = US risk free rate + Project Beta * US market risk premium

= 3% + 1.5 * 5.5%

Required return (Cost of equity) = 11.25%

C. Required rate of return if country risk same as market place of Assets (Argentina)= 28.1%

Required return = Risk free rate in the US + Beta * Argentina market risk premium

= 3% + 1.5 * 16.75%

Required return = 28.1%

d) If Argentina credit default swap premium is 400 bps and equity market volatility is 1.4 times bond market

Argentina country risk premium = 1.4 * 4% = 5.6%