Definition:

Country risk is the risk that a foreign government will default on its bonds or other
financial commitments. Country risk also refers to the broader notion of the degree to
which political and economic unrest affect the securities of issuers doing business in
a particular country.

How it works (Example):

Let's assume that you are considering purchasing either a bond issued by the
government of Canada or a bond issued by the government of Nigeria. Both
governments intend to use the funds for similar projects. Which bond is more likely
to default? That depends in part on your assessment of country risk .

Political and economic instability are two of the biggest reasons countries default on
their bonds, so the question of determining country risk is at least partially a matter of
comparing these factors for Canada and Nigeria. Analysts scrutinize tax systems, the
influence of certain political parties, evidence of corruption, inflation rates, education
systems, demographics, and a wide variety of other factors to determine and predict
sources of instability.

Two Main Sources of Country Risk

A country's risk can generally be divided into two groups:

1. Economic Risk:

Risk associated with a country's financial condition and ability to repay its debts. For
instance, a country with a high debt-to-GDP ratio may not be able to raise money as
easily to support itself, which puts its domestic economy at risk.

2. Political Risk:

Risk associated with a country's politicians and the impact of their decisions on
investments. For instance, desperate politicians supporting nationalizations could
pose a risk to investors in certain strategic industries.

Both these areas need to be positive. It goes without saying that a country with a
strong economy is unlikely to be a good place to invest if its politically unstable.
Measuring Country Risk

Measuring a country's risk can be a tricky endeavor. From tax laws to political
upheaval, investors have to take hundreds, if not thousands, of different factors into
consideration. For instance, tangible moves like an interest rate hike can dramatically
hurt or help a country's businesses and stock market. But even a mere comment from
a prominent politician hinting at future plans can have just as large of an impact. A
lot also depends on the market's existing expectations before the move or rumored
move.

Analyzing Country Risk

There are many different ways to analyze a country's risk.

From beta coefficients to sovereign ratings, investors have a number of different tools
at their disposal. International investors should use a combination of these techniques
in order to determine a country's risk, as well as the risk associated with any
individual international investment or security.

Methods used to assess country risk can be grouped into two categories:

Quantitative Analysis:

The use of ratios and statistics to determine risk, such as the debt-to-GDP ratio or the
beta coefficient of the MSCI index for a given country.

International investors can find this information in reports from ratings agencies,
magazines like the Economist, and through various online sources like Wikipedia.

Qualitative Analysis:

The use of subjective analysis to determine risk, such as breaking political

news/opinion or realistic market rumors.

International investors can find this information in financial publications like the
Economist and the Wall Street Journal, as well as by searching on international news
aggregators like Google News.

But, the most common way that investors assess country risk is through sovereign
ratings. By taking these quantitative and qualitative factors into account, these
agencies issue credit ratings for each country and give investors an easy way to
analyze country risk.
Other Techniques of Assessing Country Risk
Checklist approach

A checklist approach involves rating and weighting all the identified factors, and then
consolidating the rates and weights to produce an overall assessment.
A checklist approach will require the following steps:

Assign values and weights to the political risk factors.

Multiply the factor values with their respective weights, and sum up to give the
political risk rating.
Derive the financial risk rating similarly.
Assign weights to the political and financial ratings according to their perceived
importance.
Multiply the ratings with their respective weights, and sum up to give the overall
country risk rating.
Delphi technique
The Delphi technique involves collecting various independent opinions and then
averaging and measuring the dispersion of those opinions.

Inspection visits
Inspection visits involve traveling to a country and meeting with government
officials, firm executives, and/or consumers to clarify uncertainties.

NOTE

Often, firms use a variety of techniques for making country risk assessments.

For example, they may use a checklist approach to develop an overall country risk
rating, and some of the other techniques to assign ratings to the factors considered.

Comparing risk ratings among countries

One approach to comparing political and financial ratings among countries is the
foreign investment risk matrix (FIRM).The matrix measures financial (or economic)
risk on one axis and political risk on the other axis. Each country can be positioned
on the matrix based on its political and financial ratings.
Important Steps When Investing Overseas
Once country analysis has been completed, several investment decisions need to be
made. The first is to decide where to invest by choosing among several possible
investment approaches, including investing in:

a broad international portfolio

a more limited portfolio focused on either emerging markets or developed
markets
a specific region, such as Europe or Latin America
a specific country(s)

Remember that diversification, a fundamental principle of domestic investing, is even

more important when investing internationally. Choosing to invest an entire portfolio
in a single country is not prudent. In a broadly diversified global portfolio,
investments should be allocated among developed, emerging and perhaps frontier
markets. Even in a more concentrated portfolio, investments should be spread among
several countries to maximize diversification and minimize risk.
After deciding where to invest, an investor must decide which investment vehicles to
invest in. Investment options include sovereign debt, stocks or bonds of companies
domiciled in the country(s) chosen, stocks or bonds of a U.S.-based company that
derive a significant portion of revenue from the country(s) selected, or an
internationally focused ETF or mutual fund. The choice of investment vehicle
depends on each investor's individual knowledge, experience, risk profile and return
objectives. When in doubt, it may make sense to start out by taking less risk. More
risk can always be added to the portfolio later.

Conclusion
Overseas investing involves a careful analysis of the economic, political and business
risks that might result in unexpected investment losses. This country risk analysis is a
fundamental step in building and monitoring an international portfolio. Investors that
use the many excellent information sources available to evaluate country risk will be
better prepared when constructing their international portfolios.