📘 Chapter 5 – Country Risk: Determinants, Measures, and Implications

🎯 Exam Learning Goals

You should be able to:

 Explain the determinants of country risk

 Identify measures used to quantify it (economic, political, legal, total, and sovereign)

 Understand sovereign default risk and its impact

 Interpret credit spreads and ratings as measures of country risk

🔹 5.1 Evaluation of Risk

Country risk = probability that political, economic, or social instability will cause financial
losses for investors, lenders, or firms.

It matters to:

 Investors in foreign bonds/equities

 Banks lending across borders

 Multinationals expanding abroad

Economic Risk

Measured via GDP growth, inflation, unemployment, and currency stability.

 GDP growth rate = nominal change

 Real GDP growth rate = adjusted for inflation

✅ Stable and positive real GDP growth → lower risk.

Developing countries often face sharp volatility due to dependence on few exports (e.g., oil,
metals).

📍 Mnemonic: “Real reveals reality” → real GDP reflects true growth.

Political Risk

= risk that government actions or instability reduce profitability.

Components:
 1. Government changes or coups

2. Corruption

3. Civil unrest or war

4. Nationalization / Expropriation – when government seizes assets (common in

energy & mining).

5. Violence / Terrorism – captured by Global Peace Index (GPI)

 Low GPI score = peaceful → investor-friendly

 High GPI = instability → risky

📍 Italic term: Expropriation = seizure of private assets by government with little or no

compensation.

Example: Oil firms in Venezuela and Libya faced expropriation during political instability.

Legal Risk

= risk of losses due to inadequate, corrupt, or biased legal systems.

 A fair, independent, and efficient judiciary attracts foreign capital.

 Property rights and contract enforcement are crucial.

Measured by: International Property Rights Index (IPRI) — covers:

1. Legal & Political Environment

2. Physical Property

3. Intellectual Property

Example:
🇺🇸 U.S. IPRI ~8.2 (strong protection)
🇷🇺 Russia ~5.0 (weak enforcement)

📍 Italic term: Property rights refer to enforceable ownership and legal recourse.

The Economy

 Commodity dependence increases vulnerability.

 Diversification (e.g., Saudi Arabia’s Vision 2030) reduces economic concentration risk.
🔹 5.2 Total Risk

Is there a single number for “country risk”?

Yes — Composite indices from agencies like:

Agency Basis of Rating

Political Risk Services (PRS) 22 indicators: political, financial, and economic

Euromoney Survey of economists

The Economist Intelligence Unit (EIU) Currency, debt, and banking risks

World Bank Corruption, rule of law, accountability

⚠️Scores differ by source → rankings are more important than raw numbers.

📍 Italic term: Composite risk index = combined political, financial, and economic measures.

💡 Memory Trick: “PRESS” → PRS, Ratings, Economist, Scores, Surveys.

🔹 5.3 Sovereign Credit Risk

A country’s default risk on debt is a key part of total country risk.

1️⃣ Foreign Currency Debt

 Issued in currency not controlled by the borrower (e.g., Argentina borrowing in USD).

 Can’t be repaid by printing money.

 Hence, higher risk.

Recent defaults (2010–2018):

 Greece (2012): 70% investor loss

 Cyprus, Ukraine, Venezuela — multiple defaults

📍 Italic term: Sovereign default = failure to meet principal/interest obligations.

2️⃣ Local Currency Debt

 Issued in domestic currency.

 Can be repaid by increasing money supply, but causes inflation and currency
depreciation.

 Less risky than foreign-currency debt in most cases.

3️⃣ Impact of a Default

 Credit restructuring (lower principal, longer maturity, or reduced interest).

 Default damages reputation → temporarily blocks access to global markets.

 Debt markets often forgive over time if reforms occur.

💡 Memory Trick: “Default DROWNS” → Debt Restructure, Reputation loss, Outflows stop,
Weak access, New borrowing tough, Spread rise.

🔹 5.4 Sovereign Credit Ratings

Provided by Moody’s, S&P, and Fitch.

Two types:

1. Foreign Currency Rating

2. Local Currency Rating

Trends:

 Local currency debt generally performs better than foreign.

 Country ratings are more stable than corporate ratings.

📍 Italic term: Sovereign credit rating = agency’s assessment of a nation’s ability/willingness

to repay.

🔹 5.5 Credit Spreads

= Difference between country’s borrowing rate and risk-free rate in same currency.
Credit Spread=icountry −i risk-free

 Reflects default and liquidity risk.

 Moves more frequently than ratings → timelier measure of risk.

Example:
If U.S. 10-year = 3% and Brazil = 9% → spread = 6%.

⚙️CDS (Credit Default Swaps)

 Provide market-implied measure of sovereign risk.

  Speculators can buy protection without owning bonds (“naked CDS”), but EU banned
uncovered sovereign CDS after 2010.

📍 Italic term: Credit spread clustering = when CDS spreads of different countries move
together even without shared fundamentals.

💡 Memory Trick: “CDS = Country Default Signal.”

🧾 Chapter Summary (Exam POV)

Risk Type Key Driver Example

Economic GDP, inflation, exports Venezuela’s negative GDP

Political Corruption, war, coups Syria, Sudan

Legal Weak property rights Russia

Sovereign Debt defaults Greece 2012

Credit Spread Market premium Brazil–U.S. 6% gap

🧠 Memory Table

Concept Mnemonic Meaning

Economic Risk “Real reveals reality” Real GDP = true growth

Political Risk “Peace keeps profit” Low GPI = low risk

Legal Risk “Law loves investors” Fair courts attract capital

Composite Index “PRESS” PRS, Ratings, Economist, Surveys, Scores

Sovereign Default “DROWNS” Debt restructure, reputation hit, etc.

Credit Spread “Country Default Signal” Market-implied country risk

🎯 Likely FRM Exam Questions

1. Identify determinants of country risk

2. Distinguish foreign vs local currency default

3. Interpret composite risk scores

4. Explain impact of default on economy

 5. Discuss CDS and sovereign spreads

6. Compare country vs corporate ratings

7. Describe legal risk and property rights

8. Apply GDP growth rates to risk assessment

9. Explain why local-currency debt performs better

10. Interpret correlation between political risk and investment flows

🏆 10 High-Yield Practice MCQs

Q1. Which of the following best defines country risk?

👉 C. The potential for losses due to political, economic, or social instability

Q2. Real GDP growth differs from nominal because it:

👉 A. Adjusts for inflation

Q3. Which index measures levels of violence and stability?

👉 B. The Global Peace Index

Q4. Expropriation refers to:

👉 C. Government seizure of private assets with inadequate compensation

Q5. Weak property rights indicate high:

👉 A. Legal risk

Q6. Foreign currency debt is riskier than local currency debt because:
👉 B. The borrower cannot print the repayment currency

Q7. Which service combines political, financial, and economic indicators into a single risk
score?
👉 C. Political Risk Services (PRS)
Q8. Sovereign defaults usually result in:
👉 A. Restructuring with lower interest or longer maturities

Q9. Which is a more timely measure of country risk?

👉 B. Credit spreads

Q10. The European Union banned uncovered sovereign CDS because:

👉 C. They allowed speculation without actual exposure

✅ Final Takeaway

Country risk reflects how political, legal, and economic instability affects investment returns.
FRM focuses on how GDP, corruption, legal systems, default history, ratings, and credit
spreads quantify and compare that risk across nations.