# FRM Fun 2

Discussion in 'Today's Daily Questions' started by Suzanne Evans, Jul 3, 2012.

FRM Fun 2.

Please see yesterday's post by Aswath Damodaran "Equity Risk Premiums: Globalization and Country risk" at http://aswathdamodaran.blogspot.com/2012/07/equity-risk-premiums-globalization-and.html. This question is based on his post.

Assume the global risk-free rate is 2.0%. According to Damadoran, the equity risk premium (ERP) for US equities is currently about 6.0%. You want to estimate the value of an Italian stock that pays a (its next) dividend of 10.0 Euros per year, with the dividend growing at 4.0% per year, using the Gordon Growth Model. The Italian stock's beta (with respect to Italian equities) is 1.40. You do want to adjust the ERP to account for Italian country risk; and you decide to follow Damadoran's Relative Equity Market Volatility approach: "you can scale up the equity risk premium by the relative volatility of the country in question, with relative volatility computed as the ratio of the volatility of that market to the volatility in the S&P 500." According to his data (see XLS), Italy's equities volatility is about 30% compared to a US volatility of 20%, which amounts to a relative volatility of 1.50. What is the value estimate of the growing Italian dividend stream?

A. EUR 68.49
B. EUR 94.34
C. EUR 142.86
D. EUR 156.25

Ans. B 94.34

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Now is anyone able to provide an explanation and/or added value?

Thanks,
Suzanne

4. ### ShaktiRathoreWell-Known Member

Yeah i might like to explain the answer as:
The beta of stock acc. to US risk is 1.4
Taking into accoun the risk of foreign stock as mentioned thru volatilities the adjusted Beta is:
1.4*(volatility of italy eqty./volatility of US eqty.)=1.4*(30%/20%)=1.4*1.5=2.1
Applying the CAPM:
the cost of equitt for the stock is Beta(adj.)*Eqty Risk premium+risk free rate
=2.1*6%+2%=14.6%
Now Applying the GGM model for equity valuation:
=Div/cost of equtiy-growth
=10/(14.6%-4%)
=10/.106

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5. ### David Harper CFA FRMDavid Harper CFA FRM (test)Staff Member

@shaktisira: thanks for your correct explanation! In addition to addityafrm (for giving the first correct answer), you are entered once in the drawing, for posting a value add (drawing results will be posted each Monday), thanks