Which Players Are Worried About Country Risk?
Large Business Firms
Investors
Banks lending Sovereign
Sources / Components of Country Risk
PLEDGE Economic Growth in
Political Risk Legal Risk
Diversification economy
Political Risk 1. Dictatorship vs Democracy
Discontinuous Risk Continuous Risk
(Dramatic Change) Risk of Instability
Stable and fixed policies
2. Corruption- Implicit and uncertain cost/tax
Corruption
index 3. Physical violence- Economic costs (insurance) and physical harm
Global peace
index 4. Nationalization/Expropriation risk- Seize foreign firm assets by paying little
Legal Risk
Effective legal system with protection of property rights and
timely enforcement of contracts
Minimal govt. interference
Fair rules for rights of S/Hs
Eg. Strict laws against insider trading
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Economic Diversification
Level of dependence on a particular product
Competitive advantage in terms of:
Factor conditions
demand conditions
Related and supporting industries
Firm strategy, structure, rivalry
Stages of Economic Growth Cycle
1. Countries in early growth More sensitive to
2. Countries with heavy reliance on commodities recession
Composite Measure of Risk
Political Risk World Bank
Euromoney Economist
Services Database
Features:
1. More relevant for policy makers and macro economists
2. Scores are not standardized
3. More useful for ranking rather than absolute or relate risk levels
Narrative accompanying a score is more imp. than score itself
Sovereign Default Risk
(Ability)
Ratings Sovereign CDS
Factors influencing
Local currency Foreign currency
Ratings
Ratings Ratings
Ratings Features
Consequences of sovereign default (Willingness)
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Factors implementing Rating
1. Income side
Revenue/inflows to govt
Tax Receipts (well diversified sources)
2. Expense Side
Pensions/Social service commitments
3. Liability side
Debt/GDP ratio the higher the riskier (exception Japan)
Also split by
• States
• Local citizens/banks and foreign investors
4. Asset Side
5. Off b/s
Capacity to print money is a function of independence and power of central bank
Implicit backing from other entities
Products
Rating features
1. Products
Providers Local currency
Foreign currency
Pros money printing
Procedure
Bank debt default
Persistence ST attractive
more likely than
Problems LT negatives
sovereign debt
Pros Providers
Similar to
Familiarity S&P Moody’s
corporates
PD
and LGD
PD
Procedure
Start with corporate Draft report rating
Vote of rating committee
rating recommended action
Fine turned for sovereigns Notch up and notch down
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Persistence
Ratings are sticky, very infrequent changes
Problems
Heard behaviour, lack of independence, upward bias, regional biases
Lagged alarms
Vicious cycle- too drastic changes- too late
Sovereign CDS
Implied from market prices of Govt Bonds or credit default swaps
1. Insurance contracts traded on corporations as well as countries
2. Used by both hedgers and speculators
Advantages Disadvantages Efficacy
Higher granularity More volatile than High correlation
compared to ratings ratings with defaults
Dynamic updates Also impacted by leading indicator
extraneous non- have inf. value
credit variables e.g.,
Liquidity, investor
demand
Consequences of sovereign default (Willingness)
Willingness depends on the impact of default
1. Reputation Loss
2. Capital Market and Banking turmoil
3. Fall in real output
4. Political instability
5. Austerities
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