Country Risk
July 21, 2021
What is “Country Risk”?
Country risk is associated with the risk of investing in a particular country and the degree of uncertainty that could result in financial loss. When assessing this type of risk, investors should consider several factors including economic and political climate, currency and overall stability.
Country risk is also closely linked to sovereign risk, which determines the possibility of a government missing its financial obligations, for example default risk of sovereign bonds. In addition, country risk can impact the performance of securities of companies that operate in that country.
Key Learning Points
- Country risk is described as the risk of experiencing financial loss when investing in a particular country;
- It is closely related to sovereign risk, which determines the possibility of a sovereign country or government missing its financial obligations;
- Investors should consider a number of important factors when assessing the risk of investing in a particular country such as economic and political stability, exchange rates, regulation, technological advancement and consumer patterns; and
- There are different techniques that help investors to quantify the country risk such as the Debt-to-GDP ratio or analyzing the MSCI Index data. Major rating agencies also provide guidance/ratings for sovereign risk.
The Basics of Country Risk
Typically, investors consider allocating funds to developed countries to be less risky relative to countries from emerging markets. While the United States is considered to be the benchmark for a low country risk, investors need to pay attention to various qualitative and quantitative factors when investing in less-developed countries. Economic and political stability are at the core of country risk assessment as they can significantly impact the expected return on investment. Monetary policy, inflation and exchange rates, along with fiscal policy and regulation should also be considered as major components of overall country risk.
In terms of sovereign debt, the likelihood of a country missing its payments is assessed by major rating agencies such as Standard and Poor’s, Moody’s and Fitch. They issue ratings based on a complex analysis that incorporates both historical (such as track record of previous payments) and future (economic outlook) factors. Investors typically use these ratings as guidance when assessing sovereign risk.
How to Evaluate Country Risk?
Along with credit ratings and qualitative factors such as political and country news, economic review and outlook (for example the one produced by the Organisation for Economic Co-operation and Development or OECD) investors could use a number of quantitative tools that can help them assess country risk. Analysing the correlation and beta coefficients through the MSCI Index of a particular country is a common strategy of evaluating the risk of investing in a given country or location. Statistical measures such as the Debt-to-GDP are also important, as normally a high ratio means that the country may struggle to raise additional funds should the domestic economy needs additional support.
The Bottom Line
Investors should be aware that while hedging may be an efficient strategy to protect their portfolio against exchange rate (also known as currency) risk, other uncertainties such as political instability are very difficult to predict. Foreign direct investments (FDIs) that are not made through an exchange and have low levels of liquidity are usually most vulnerable to country risk.
Example- Country Risk Question
Below is a question on which country represents the highest risk:
