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Weigh up the ways country risk is measured and review the weaknesses of those ways.

FRM® Part II · Credit Risk Measurement and Management · Country Risk: Determinants, Measures, and Implications · FRM2.CR.8.b

The idea

Country risk is measured in three broad ways. These are sovereign ratings and the default spreads attached to them, composite risk scores from services such as the PRS Group (ICRG), Euromoney or the Economist Intelligence Unit, and market-based premiums. A common way to turn a default spread into an equity premium scales it by relative volatility, because equity is riskier than the bond. In the next line, CRP is the country risk premium, and the two volatilities are those of the equity market and of the sovereign bond. CRP = default spread × (equity volatility ÷ bond volatility). The weaknesses are well known. Scores are subjective and ordinal, so they rank countries without saying how much extra return to demand. Providers use different weights and opposite scale directions, and ratings and scores lag events. A country-level premium also ignores that companies are exposed through operations and revenues, not through where they are incorporated, so premiums should be weighted by exposure.

Formulas

Equity country risk premium from relative volatility

CRP = default spread × (σequity ÷ σbond)

default spread
the sovereign's default spread
σequity
the volatility of the country's equity market
σbond
the volatility of the sovereign bond

Scales up because equity is riskier than the bond. Inverting the ratio gives a premium below the spread, which is the trap.

Exposure-weighted country risk premium for a company

CRP = Σ wᵢ × CRPᵢ

wᵢ
the share of the company's revenue earned in country i
CRPᵢ
the country risk premium of country i

Weight by where revenue is earned, not by the country of incorporation, and include mature markets at zero.

A practice question

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

Which of the following is a recognised way of measuring country risk?

  1. The price-to-earnings ratio of the country's equity index. It rises and falls with growth expectations, interest rates and sentiment, so it cannot rank countries by risk.Why not: A valuation multiple reflects pricing and growth expectations, not a measure of country risk.
  2. A composite risk score from a service such as the PRS Group's ICRG, Euromoney or the Economist Intelligence Unit. - correct
  3. The size of the country's nominal GDP.Why not: Size says nothing about political, legal or default risk; large economies can be risky.
  4. The Sharpe ratio of the country's equity market over the past year.Why not: A past performance ratio for a portfolio is not a measure of the risks arising from a country.

Risk services publish composite scores combining political, economic and financial factors, and agencies publish sovereign ratings. P/E, GDP size and Sharpe ratios are not country risk measures.

A harder one

An analyst averages the raw scores of two risk services for a set of countries. Service 1 scores 0 to 100 with higher meaning safer. Service 2 scores 0 to 100 with higher meaning riskier. What is the main problem with this approach?

  1. The scales run in opposite directions and have different meanings, so the scores must be aligned before they can be combined. - correct
  2. None, since averaging two scores always cancels the subjectivity of each.Why not: Averaging does not remove bias or fix scales running in opposite directions; the result would be meaningless.
  3. The services measure different currencies, so the average must be converted to dollars. Index scores are pure numbers, so there is no unit conversion to be done.Why not: Scores are dimensionless indices; no currency conversion is involved.
  4. The averages will always be 50, since both scales run from 0 to 100.Why not: An average of two scores depends on the data; the scales share a range, not values.

Providers differ in direction, weights and factors. Raw scores can be combined only after aligning direction and scale, and even then the result is an ordinal ranking, not a price of risk.

The hardest tier

A sovereign's foreign currency bond trades with a default spread of 2.8 percent. The country's equity market has annualised volatility of 21 percent and its government bond has annualised volatility of 14 percent. Using relative volatility, the equity country risk premium is closest to:

  1. 1.9 percentWhy not: Inverts the ratio (14/21 instead of 21/14), so the premium comes out below the bond spread.
  2. 4.2 percent - correct
  3. 2.8 percentWhy not: Uses the bond default spread as the equity premium without scaling for the higher risk of equity.
  4. 1.4 percentWhy not: Scales by the excess of the volatility ratio (0.5) instead of the ratio itself.

CRP = default spread x (equity volatility / bond volatility) = 2.8% x (21 / 14) = 2.8% x 1.5 = 4.2%.

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