FRM Part 1

Book 4 - Valuation and Risk Management

COUNTRY RISK
 Learning Objectives
After completing this reading you should be able to:
 Identify sources of country risk.
 Explain how a country’s position in the economic growth life cycle, political
risk, legal risk, and economic structure affect its risk exposure.
 Evaluate composite measures of risk that incorporate all types of country risk
and explain limitations of the risk services.
 Compare instances of sovereign default in both foreign currency debt and local
currency debt, and explain common causes of sovereign defaults.
 Describe the consequences of sovereign default.
 Describe factors that influence the level of sovereign default risk; explain and
assess how rating agencies measure sovereign default risks.
 Describe the advantages and disadvantages of using the sovereign default
spread as a predictor of defaults.
 Sources of Country Risk
 Country risk is the risk associated with investing in a given country.
o When Apple, for example, pushes for a bigger market presence in
Latin America, they are exposed to the political and economic
turmoil that plagues these markets.

 Country risk could be attributed to the following:

o A country’s position in the economic growth life cycle;
o Differences in political risk;
o The legal system; and/or
o Disproportionate dependence on certain products or services.
 A Country’s Position in the
Economic Growth Cycle
 Countries in early growth are more exposed to risk than larger, more
mature countries.
o For instance, while countries like Japan and the U.K. experience a
1-2% dip in GDP following a recession, early growth economies
like Kenya and Panama can record a dip as high as 5%.

 Even in the face of a robust legal framework and good governance,

there’s an upper cap on the powers that countries have over their risk
exposure.
o Some risks may simply be unavoidable.
o This is why it’s important to thoroughly analyze a country’s risk
profile before making critical investment decisions.
 Differences in Political Risk
The political environment in a country can have a major bearing on its
risk exposure. This can particularly be explained in four main ways:
 Continuous vs. Discontinuous risk:
o Countries deeply rooted in democracy and free speech have
continuous risk in the sense that rules and regulations
governing are continuously being challenged and amended.
o In authoritarian states, on the other hand, dictatorial policies create
discontinuous risk. That means it may be difficult to amend
rules and regulations however good or bad they might be from the
perspective of the investor.
 Corruption and Side costs:
o The rules and regulations governing business and operations in a
country are only as good as the systems put in place to enforce
them. High levels of corruption make it easy to circumvent
regulations or ignore them outright.
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 Differences in Political Risk
 Physical violence:
o Internal conflicts or civil war expose investors to both physical
harm and heavy operational costs, including high insurance costs
and depreciation of physical assets.
 Expropriation risk:
o Expropriation risk is the risk that a government may seize
ownership of a firm’s assets or impose certain rights that
collectively reduce the firm’s value.
 Compensation for expropriation may be well below the value of
rights or assets relinquished.
o Mining firms would be a good example of firms constantly under
expropriation risk.
 Legal Risk
 Legal risk has much to do with the enforcement of property/contractual
rights and fidelity to the rule of law.
o Laxity toward enforcement of rules and regulations not only
disadvantages current investors; it also serves to discourage
potential investors from coming in.

 Legal risk is also a function of how efficiently the system operates.

o For example, if enforcing a contractual right takes many years in
a given country, investors will most likely shun that country.

 Some countries are known to have (and enforce) very robust

property rights, especially in North America.
o Others have very weak enforcement, especially African and South
American countries.
 Disproportionate Dependence
on Certain Products or Services
 A country that depends too much on one product or service
exposes investors to additional risk.

 A decline in the price or demand of the product or service can create

severe economic shocks that may reverberate well beyond the
companies immediately affected.
o For example, a country whose oil proceeds amount to, say, 50%
of the GDP, exposes all investors within the country to economic
pain if the price of oil tumbles.
 Composite Measures of Risk:
Risk Services
There are several professional organizations around the world that offer
country risk measurement services:
 Political Risk Services (PRS) is a subscription-based service that offers
members extensive risk analysis of over 100 countries based on three core
dimensions: political, financial, and economic.
 Euromoney is an organization that uses surveys of 400 prominent
economists to come up with a composite risk score of a country or region.
o The score ranges from 0 to 100.
 The Economist is the popular media house develops in-house country risk
scores built upon currency risk, sovereign debt risk, and banking risk.
 The World Bank develops country risk scores based on six key indicators.
These are corruption, government effectiveness, political stability, regulatory
quality, rule of law, and accountability.
o The WB’s scores are scaled around zero, with negative numbers indicating
more risk and positive numbers less risk.
 Limitations of Risk Services
 Limitations of risk services include:
o Some of the models used to churn out the final risk score incorporate
risks that have very little impact on business. The final score could be
appropriate for policy making or economic reading but otherwise
irrelevant for investors.
o There’s no standardization of scores, and each service uses its own
protocol and calibration techniques.
o The scores can be quite misleading when used to measure relative risk.
For example, if a country has a PRS score of 80, that doesn’t imply it’s
twice as safe as another country with a score of 40.
 Sovereign Default
A sovereign default is the failure or refusal of the government of a sovereign
state to pay back its debt in full. Sovereign debt can be denominated in either
local or foreign currency.
1. Foreign currency defaults
 Foreign currency defaults are defaults that occur on sovereign currency
that’s denominated in foreign currency. In most cases, governments find
themselves unable to raise the amount of foreign currency required to meet
contractual obligations.
 The worst thing about foreign currency debt is that governments cannot
print foreign currency to make up for the shortfall.
o In dollar value terms, Latin American countries have accounted for
much of sovereign defaulted debt in the last 50 years.
 Sovereign Default
 Some countries have previously defaulted on debt denominated in local
currency.
o Examples include Argentina (2002-2004) and Russia (1998-1999).
 Local currency defaults could be traced down to three main reasons:
1. Mandatory gold backups: In the years prior to 1971, printed currency had to
be backed up with gold reserves. Without enough reserves, countries could
not print enough cash to pay up debts.
2. Presence of shared currencies: When a country shares a currency with
other countries, it lacks the freedom to print cash to prevent a sovereign
default.
o This scenario played out in 2015 whereby the Greek government could
not print more Euros even in the face of a crippling economic meltdown
punctuated by a huge sovereign debt.
3. A reluctance to print cash purely for debt repayment: Printing cash to
meet debt obligations is fraught with dangers, including reputation risk,
political instability, and the very real possibility of an economic recession.
Consequences of Sovereign Default
 Reputation loss
o Sovereign default can lead to a dramatic deterioration of both
diplomatic and economic ties between states.
 Political instability
o Following a sovereign default event, the populace may lose its
confidence in their leadership, leading to wave after wave of demos,
unrest, as well as coups in extreme cases.
 Real output declines
o As investors increasingly shun financial assets in favor of real assets,
domestic consumption may also decrease. This, in turn, may lead to a
drop in production
 Capital markets are thrust into a state of chaos and turmoil
o Following a default event, investors increasingly grow reluctant to
commit their funds in long-term investments.
 Factors that Influence the
Level of Sovereign Default Risk
 Degree of indebtedness
o The larger the debt a sovereign state has, the more likely it is to default on part of
the debt.
 The size of revenue
o A high amount of revenue reduces the chances of a sovereign default event
occurring.
 Stability of revenue
o Countries with more stable revenue streams have less default risk.
 Political Risk
o If the leadership of a country is somewhat immune from public pressure –
something common in autocracies like Iran and other Middle East nations – default
events can easily occur.
 The level of backing/support a country enjoys courtesy of other sovereign
states
o Countries that form part of a regional economic block usually offer each other
some implicit backing on matters debt. For example, an EU member state is
unlikely to default on a sovereign debt because other EU countries are likely to chip
 How Rating Agencies Measure
Sovereign Default Risks
 Rating agencies offer opinions on a firm or country’s ability to incur
and/or pay back debt. While assessing sovereign risk, agencies consider:
o Political and social risks – including issues like public participation in
political decision making, respect for the rule of law, transparency in
government, and long-term stability of political institutions.
o International security – including the safety and security of a
country’s borders.
o Regime legitimacy
o Power and governance structures in place
o Existing government obligations – including both local and foreign
debt
 Shortcomings of Ratings and
Rating Agencies
 Ratings are upward biased
o In general, rating agencies have been accused of being far too
optimistic in their assessment of sovereign ratings.
o An upward bias on corporate ratings could be explained by the fact
that the same corporates double up as the credit agencies’
remunerators.
o This argument, however, does not hold when it comes to sovereign
ratings because individual governments are not required to pay the
rating agencies.
 They are at times reactive rather than proactive
o Rather than updating their ratings before an actual credit event occurs,
rating agencies sometimes downgrade countries after a problem
has become evident.
o This does little to protect investors.
>>
 Shortcomings of Ratings and
Rating Agencies
 Too much interdependence
o Although rating agencies claim to work independently albeit using
similar risk indicators, they have been accused of exhibiting herd
behavior, so that an upgrade/downgrade by one agency is soon
replicated by other agencies.
o As such, independence is lost.
 Vicious cycle
o Sometimes rating agencies have been accused of worsening a crisis
by unduly downgrading ratings – painting a situation as being
worse than it actually is.
 Sovereign Default Spread
Sovereign default spread describes the difference between the rate of
interest on a sovereign bond denominated in a foreign currency and the
rate of interest on a riskless investment in that currency.

U.S.
Moody’s $ 10-Year Default
Country T.Bond
rating Bond Rate Spread
Rate
Argentina B3 6.96% 2.85% 4.11% More risk
Turkey Baa2 6.15% 2.85% 3.30%
Peru 3.55% 3.55% 2.85% 0.70%
Chile 3.35% 3.35% 2.85% 0.50% Less risk

>>
 Sovereign Default Spread
Advantages of Using the Sovereign Default Spread
 Compared to rating agencies, the market differentiation for risk is more
granular.
 Market-based spreads reflect changes in real time, unlike credit ratings
which can be reactive rather than proactive.

Disadvantages of Using the Sovereign Default Spread As a

Predictor of Defaults
 Market-based spreads tend to be far more volatile than credit ratings
and can be affected by variables with little or no correlation to default.
 Book 4 - Valuation and Risk Management

COUNTRY RISK
Learning Objectives Recap:
 Identify sources of country risk.
 Explain how a country’s position in the economic growth life cycle, political
risk, legal risk, and economic structure affect its risk exposure.
 Evaluate composite measures of risk that incorporate all types of country risk
and explain limitations of the risk services.
 Compare instances of sovereign default in both foreign currency debt and local
currency debt, and explain common causes of sovereign defaults.
 Describe the consequences of sovereign default.
 Describe factors that influence the level of sovereign default risk; explain and
assess how rating agencies measure sovereign default risks.
 Describe the advantages and disadvantages of using the sovereign default
spread as a predictor of defaults.