Home > Doc > Measuring Company Exposure to Country Risk: Theory and Practice > Measuring Country Risk Premiums

Measuring Company Exposure to Country Risk: Theory and Practice

Measuring Country Risk Premiums

While there are several measures of country risk, one of the simplest and most easily accessible is the rating assigned to a country’s debt by a ratings agency (S&P, Moody’s, Fitch and IBCA all rate countries). These ratings measure default risk (rather than equity risk) but they are affected by many of the factors that drive equity risk – the stability of a country’s currency, its budget and trade balances and its political stability, for instance3.

Consider Brazil, as an example. In September 2003, the Brazilian government has dollar denominated C-Bonds outstanding, with ten years to maturity. S&P rated the Brazilian government C-bond at B+ whereas Moody’s assigned a B2 rating to the same bond. While ratings provide a convenient measure of country risk, there are costs associated with using them as the only measure. First, ratings agencies often lag markets when it comes to responding to changes in the underlying default risk. Second, the ratings agency focus on default risk may obscure other risks that could still affect equity markets. What are the alternatives?

There are numerical country risk scores that have been developed by some services as much more comprehensive measures of risk. The Eurasia Group, for instance, has a score that runs from 0 to 100, where 0 is no risk, and 100 is most risky, that it uses to rank emerging markets. In September 2003, the country risk score for Brazil, based upon this measure, was 61. Alternatively, country risk can be estimated from the bottom-up by looking at economic fundamentals in each country. This, of course, requires significantly more information than the other approaches.

Measuring Country Risk Premiums

If country risk matters and leads to higher premiums for riskier countries, the obvious follow-up question becomes how we measure this additional premium. In this section, we will look at three approaches. The first builds on default spreads on country bonds issued by each country whereas the latter two use equity market volatility as their basis.

1. Country Bond Default Spreads

The simplest and most widely used measure of country risk comes from looking at the yields on bonds issued by the country in a currency (such as the dollar or the euro) where there is a default free bond yield to which it can be compared4. Consider the dollar denominated Brazilian C-Bond that we highlighted earlier in this section.

The C-Bond is widely traded and both the price and yield of the bond reflect market views of Brazil. In September 2003, the 10-year C-bond was priced to yield 10.12%. Comparing this yield to the 10-year U.S. treasury bond rate of 4.11% generates a default spread of 6.01% for the Brazilian bond. While we can make the argument that the default spread in the C-Bond is a reasonable measure of the default risk in Brazil, it is also a volatile measure. In figure 1, we have graphed the yields on the C-Bond and the U.S. treasury bond and highlighted the default spread.

Note that the spread widened dramatically during 2002, mostly as a result of uncertainty in neighboring Argentina and concerns about the Brazilian presidential elections5. After the elections, the spreads decreased just as quickly. Given this volatility, a reasonable argument can be made that we should consider the average spread over a period of time such as two years rather than the default spread at the moment.

Analysts who use default spreads as measures of country risk typically add them on to both the cost of equity and debt of every company traded in that country. For instance, the cost of equity for a Brazilian company, estimated in U.S. dollars, will be 6.01% higher than the cost of equity of an otherwise similar U.S. company, using the September 2003 measure of the default spread. In some cases, analysts add the default spread to the U.S. risk premium and multiply it by the beta. This increases the cost of equity for high beta companies and lowers them for low beta firms. We will consider the relative strengths of both approaches in the next section.

2. Relative Equity Market Standard Deviations

There are some analysts who believe that the equity risk premiums of markets should reflect the differences in equity risk, as measured by the volatilities of these markets. A conventional measure of equity risk is the standard deviation in stock prices; higher standard deviations are generally associated with more risk. If you scale the standard deviation of one market against another, you obtain a measure of relative risk.

This relative standard deviation when multiplied by the premium used for U.S. stocks should yield a measure of the total risk premium for any market.

Equity risk premium Country X = Risk PremumUS * Relative Standard Deviation Country X Assume, for the moment, that you are using a equity risk premium for the United States of 4.53%. The annualized standard deviation in the S&P 500 between 2001 and 2003, using weekly returns, was 18.59%, whereas the standard deviation in the Bovespa (the Brazilian equity index) over the same period was 33.37%6. Using these values, the estimate of a total risk premium for Brazil would be as follows.

The country risk premium can be isolated as follows:

Country Risk PremiumBrazil = 8.13% - 4.53% = 3.60%

While this approach has intuitive appeal, there are problems with using standard deviations computed in markets with widely different market structures and liquidity. There are very risky emerging markets that have low standard deviations for their equity markets because the markets are illiquid. This approach will understate the equity risk premiums in those markets.

The second problem is related to currencies since the standard deviations are usually measured in local currency terms; the standard deviation in the U.S. market is a dollar standard deviation, whereas the standard deviation in the Brazilian market is a nominal Brazilian Real standard deviation. This is a relatively simple problem to fix, though, since the standard deviations can be measured in the same currency – you could estimate the standard deviation in dollar returns for the Brazilian market.


Note :

3 The process by which country ratings are obtained in explained on the S&P web site at http://www.ratings.standardpoor.com/criteria/index.htm.

4 You cannot compare interest rates across bonds in different currencies. The interest rate on a peso bond cannot be compared to the interest rate on a dollar denominated bond.

5 The polls throughout 2002 suggested that Lula who was perceived by the market to be a leftist would beat the establishment candidate. Concerns about how he would govern roiled markets and any poll that showed him gaining would be followed

6 If the dependence on historical volatility is troubling, the options market can be used to get implied volatilities for both the US market (about 20%) and for the Bovespa (about 38%).

Prof. Aswath Damodaran

Next: Default Spreads + Relative Standard Deviations

Summary: Index