Country risk

Buy a bond issued by a company in your own country, and the risks are ones you already know how to price — the business, the currency you already hold, the courts you can sue in.

Buy the same kind of bond issued somewhere else, and a new layer of risk appears on top: the country itself. Its government could change policy overnight, its currency could move against you, its growth and inflation could behave nothing like your home market's.

Country risk is that extra layer — the political and macroeconomic risk that comes specifically from investing across a border, over and above the risk of the investment itself.

The workbook (Chapter 1, section 1.4.3) places country risk among its named risk types.

Its definition: country risk is "an additional dimension in international investing which is associated with the differences in various geographies and the associated political and macroeconomic risk factors." These are treated as additional variables in computing the risk premium for international investing, over and above what the same money would need if invested at home.

Investors respond by demanding an additional country risk premium (CRP) — and the workbook is specific about direction: the CRP is usually considered higher for developing countries with higher growth and inflation rates than for developed countries. A country growing faster and holding higher inflation is not automatically a worse investment, but it is priced as a riskier one.

The workbook also gives the standard method: CRPs can be computed specific to each country by using the credit default spreads on sovereign bonds of developed countries such as the US as benchmarks — how much more the market charges to insure against a given country's government defaulting, relative to a US Treasury bond, becomes the starting point for that country's premium.

The spreads are illustrative; the workbook gives the method, not the numbers.

An Indian investor is comparing two ten-year sovereign bonds for a Rs 25 lakh allocation: a US Treasury bond and a bond issued by a fast-growing but politically less stable emerging economy, Ruritania.

Using the workbook's method, the credit default swap spread on Ruritania's sovereign debt over the US benchmark is observed at 3.2 percentage points. That spread becomes the country risk premium built into any required return on a Ruritania-linked investment — over and above whatever premium the investment would need if it were purely domestic risk.

If the investor's baseline required return for a comparable US-linked instrument is 6%, the Ruritania-linked instrument would need to offer at least 6% + 3.2% = 9.2% before the extra political and macroeconomic risk of investing in Ruritania is even compensated — before any allowance for the bond's own credit quality. Ruritania's higher growth rate does not lower this premium; the workbook's own rule is that faster-growing, higher-inflation economies typically carry a higher CRP, not a lower one.

Chapter 1, section 1.4.3 (Types of risks) lists country risk among business, financial, liquidity, exchange rate, political, geopolitical, regulatory, market and interest rate risk — a set the paper likes to test by definition-matching. Expect a question that gives a short description and asks which named risk it is; country risk's distinguishing feature is that it is specifically about crossing a border, not about the investment itself.

The CRP computation method — credit default spreads on sovereign bonds benchmarked to a developed market like the US — is the other examinable point, and it connects forward to how the paper treats the required rate of return for any risk premium generally.

Country risk also appears in XXI-B's Risk chapter, from that paper's own workbook.

• Country risk is not the same as political risk. The workbook lists them separately: political risk is a major change in the political or economic environment; country risk is the broader combination of political and macroeconomic differences across geographies, of which political risk is one input.
• Country risk and country risk premium are not the same word twice. Country risk is the risk; the country risk premium is the compensation an investor demands for bearing it — a cause and its price.
• Higher growth does not mean lower country risk. The workbook's rule runs the other way: developing countries with higher growth and higher inflation typically carry a higher CRP.
• The benchmark is a developed-market sovereign, not a corporate bond. The workbook's method uses credit default spreads on sovereign bonds of developed countries such as the US.
• Country risk applies to debt and equity alike — it is a feature of the geography being invested in, not of one asset class.