VRM5 - Country Risk: Determinants, Measures, and Implications

Question 1

Explain how a country’s position in economic growth life cycle, political risk, legal risk, and economic structure affects its risk exposure

Answer 1

Developing countries have larger declines in GDP in during economic cycles

Political risk difficult to assess, democracies tend to be more volatile than authoritarianisms because of rapid shifts in policy - authoritarianism more prone to bribery and corruption

Less developed countries more likely to give rise to legal risk - that is losses arising due to inadequacies in legal system

Question 2

Evaluate composite measures of risk that incorporate all types of country risk

Answer 2

Political Risk Service (PRS) calculates index based off of combining 22 major factors, but must be taken as a guide (rankings more important than scores) and narrative sometimes key

Question 3

Compare instances of sovereign default in both foreign currency debt and local currency and explain common causes of sovereign defaults

Answer 3

Local default can occur in places like Greece where they do not have access to the central bank, foreign defaults when can’t pay back debt issued in a foreign currency

Question 4

Describe the consequences of sovereign default

Answer 4

• government may be unable to fund itself for a while
• loss of reputation making harder to borrow in the future
• political instability

Question 5

Describe factors that influence the level of sovereign default risk; explain and assess how rating agencies measure sovereign default risks

Answer 5

Agencies look at GDP to government debt, also consider social security commitments, tax base, political risk, implicit guarantees

Question 6

Describe the characteristics of sovereign credit spreads and sovereign credit default swaps (CDS) and compare the use of sovereign spreads to credit ratings

Answer 6

Credit spread on sovereign debt is excess interest rate over risk free rate in that currency

CDS can be used like insurance