The Relationship Between Potential Returns And The Underlying Risks

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The Model When making investment decisions it is important to quantify the relationship between potential returns and the underlying risks. In this situation, the client is considering making an equity investment in Country X which would expose the client to Equity, Sovereign, and Currency Risk. Equity Risk is the risk of investing in equity markets as opposed to risk-free options. Sovereign Risk is the risk that Country X will default on its debt. Currency Risk is the risk of adverse exchange rate shifts; this is primarily the relationship between inflation expectations in Country X and the US. When advising the client we must quantify the total risk exposure of the investment. This value is the required return. If the expected return is greater than the required return the investment should be made. I will use the following model in order to determine the required return: Rx = iRF-us + ERPus + SSx + CEx Please note that Rx is the required return, iRF-us is the risk-free rate in the US, ERPus is the equity risk premium in the US, SSx is the Sovereign Risk spread, and CEx is the currency exchange risk spread. These spreads on previously mentioned risks quantify the amount of return required for taking on each individual risk. External Forces Affecting SSx and CEx In order to quantify the Sovereign and Currency Risks, it is important to understand the external forces that influence their movements. A study conducted by Richard Cantor and Frank Packer called

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