What is the best estimate of the country risk premium for Zuflak？

James Sigmund, CFA, is the Head of International Equity for Pell Global Advisors (PGA). Sigmund is considering investing in the country of Zuflak as part of an emerging market portfolio. Sigmund is aware of the risks in investing in emerging markets and is preparing a valuation report regarding this investment. He estimates that Zuflak government debt would be rated BB, and has gathered the following market information for use in analyzing Zuflak.

Local Government Bond Yield= 11.50%

U.S. 10 year Treasury Bond Yield= 4.50%

U.S. BB rated Corporate Bond Yield= 7.75%

Local Inflation Rate= 6.50%

U.S. Inflation Rate= 3.00%

To assist in his analysis of Zuflak, Sigmund has asked Stefano Testorf, CFA, to estimate a value for Kiani Corporation (Kiani), Oleg Industries (Oleg), and Malik Incorporated (Malik) - the three primary companies domiciled in Zuflak that Sigmund has determined to have adequate liquidity for inclusion in PGA’s client portfolios. Testorf gives Sigmund a rough draft of his report and tells Sigmund that in order to account for country specific emerging market risks, he used a probability-weighted scenario analysis to adjust cash flows. Sigmund asks him, “Why didn’t you simply adjust the discount rate？” Testorf replies with three reasons:

Reason 1: The country risk attributable to Zuflak can be diversified away according to modern finance theory, and should not be included in the cost of capital.

Reason 2: Companies in emerging markets tend to exhibit wild price swings both up and down, therefore adjusting cash flows is the best way to account for these symmetrical country risks.

Reason 3: Although Kiani, Oleg, and Malik are all domiciled in Zuflak, each of these companies will tend to respond differently to country risks. This makes it virtually impossible to adjust the discount rate for country specific risk and come up with an accurate valuation estimate.

After careful analysis by Sigmund and his team, Sigmund decides that he wants to have exposure to Zuflak in his international portfolios. He is still unsure however, what the best way would be to establish the exposure. Sigmund discusses his concerns with Steve Solak, another portfolio manager with PGA. Solak suggests that Sigmund consider using a closed-end country fund to invest in Zuflak. Solak hands Sigmund a copy of a note that he had provided to a client listing facts about country-specific closed end funds. The note contained the followingstatements:

Closed-end country funds provide an excellent means to access local foreign markets. Even nations that have restrictions on foreign investment are sometimes accessible using closed-end country funds.

Closed-end country funds issue a fixed number of shares and are a great way to diversify a U.S.-dollar stock portfolio because of their low correlation with the U.S. stock market.

Sigmund thanks Solak for the information and heads back to his office. As he is leaving, Solak asks him if he would have time later that afternoon to discuss the use of American Depository Receipts (ADRs).