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Assess composite measures that combine several components of country risk into a single figure.

FRM® Part I · Valuation and Risk Models · Country Risk: Determinants, Measures, and Implications · FRM1.VR.5.b

The idea

A composite country risk measure combines several components, typically political, financial and economic subscores, into one number using fixed weights. The best-known example is the ICRG of the PRS Group. It scores political risk out of 100 and financial and economic risk out of 50 each. Composite = (Political + Financial + Economic) ÷ 2. The composite therefore runs from 0 to 100, and a higher score means lower risk. Check the direction of every index before comparing countries, because some providers use the opposite scale. The benefit is simplicity and breadth. The limits are subjective weights, offsetting components that hide very different risk profiles behind equal scores, and the fact that a score ranks countries but gives neither a default probability nor a premium. The exam asks you to compute a composite from subscores and to say what it cannot tell you.

Formulas

ICRG-style composite country risk score

composite = (political + financial + economic) ÷ 2

political
the political risk subscore, out of 100
financial
the financial risk subscore, out of 50
economic
the economic risk subscore, out of 50

Gives a 0 to 100 score on which higher means lower risk. Each raw point is worth half a composite point, and equal composites can hide very different subscores.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following best describes a composite country risk measure?

  1. A forecast of the probability that the sovereign defaults within one year, calibrated to historyWhy not: A composite score ranks countries; it is not a calibrated default probability.
  2. The yield spread of the sovereign's bond over the risk-free rate of the same currencyWhy not: This is a market-based credit spread, not a composite of several scored components.
  3. A statistical estimate of the volatility of the country's equity market over the past yearWhy not: Confuses a country risk score with a market volatility estimate.
  4. A single score that weights several components, such as political, financial and economic risk - correct

Composite measures, such as the PRS Group's ICRG, combine subscores for political, financial and economic risk, with set weights, into one figure for ranking countries. They are not probabilities, spreads or volatilities.

A harder one

A provider scores each of three components as a percentage of its maximum, where higher means lower risk: political 60, financial 90, economic 90. It weights political 50%, financial 25% and economic 25%. The composite is closest to:

  1. 80.0Why not: Uses equal weights instead of the stated 50/25/25.
  2. 75.0 - correct
  3. 82.5Why not: Puts the 50% weight on the economic component instead of the political one.
  4. 90.0Why not: Leaves out the political component, which carries the largest weight.

Composite = 0.50 x 60 + 0.25 x 90 + 0.25 x 90 = 30 + 22.5 + 22.5 = 75.0. The heaviest weight falls on the weakest component, so the result is below the equal-weight average of 80.

The hardest tier

Using the scale in which political (maximum 100), financial (maximum 50) and economic (maximum 50) points are added and divided by two, Country A scores 90, 20, 20 and Country B scores 50, 40, 40. Which statement is best supported?

  1. Both equal 65, but the equal scores hide different profiles; a user worried about expropriation should compare political subscores - correct
  2. Country A is lower risk overall because its political score is higher and political risk carries the largest weightWhy not: Ranks on one component, although the composite already includes the weights and both countries come to 65.
  3. Country B is riskier because its political score is lower, so its composite must be below A'sWhy not: Assumes that a lower political score forces a lower composite, ignoring B's higher financial and economic scores.
  4. Equal composites mean the two countries have the same exposure to every kind of risk, so they can be treated alikeWhy not: Overlooks that offsetting component differences are masked in the single number.

A = (90 + 20 + 20) / 2 = 65 and B = (50 + 40 + 40) / 2 = 65. The scores are identical, yet A has stronger political but weaker financial and economic components. A single figure hides this, which is the main weakness of composites.

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