Question

Please discuss about techniques for evaluating a country's risk profile and ratios that can estimate the financial health of an economy and examine secondary markets for bonds issued by developing countries, the techniques available to address defaults. (Minimum 300 words please, no plagiarism please)

Answer 1

Many investors place a portion of their portfolios in foreign securities. The decision to invest overseas should begin with determining the riskiness of the investment climate in the country under consideration. Country risk refers to the economic, political and business risks that are unique to a specific country, and that might result in unexpected investment losses.

Country risk assessment, also known as country risk analysis, is the process of determining a nation's ability to transfer payments. It takes into account political, economic and social factors, and is used to help organisations make strategic decisions when conducting business in a country with excessive risk.

1. Political risk

Political risk determines a country's political stability, either internally or externally. For instance, a recent military coup would increase a nation's internal political risk for businesses as rules and regulations suddenly shift. Other risks in this category could include war, terrorism, corruption and excessive bureaucracy (i.e. host government red tape is preventing certain fund transfers or other transactions).

Political risk can affect a country's attitude to meeting its debt obligations and may cause sudden changes in the foreign exchange market.

2. Sovereign risk

There is some crossover between political and sovereign risk, although the latter – also known as sovereign default risk – primarily examines debt. Specifically, this risk category measures the build up of debt that is the obligation of a government or its agencies (or that is guaranteed by the government), and how much said government is anticipated to fulfil these obligations.

For example, if a government agency refuses to carry out debt refunding, this could impact local lenders and lead to losses. This would of course have roll-on effects to local businesses and anyone undertaking trade with them.

3. Neighborhood risk

Neighbor hood risk, also known as location risk, may not be the direct fault of the country with which your clients are dealing, but instead is caused by trouble elsewhere. This can have spillover effects on other sovereign nations, creating turmoil in the foreign market or putting pressure on local lenders and businesses.

Neighborhood risk can be caused by:

• Geographic neighbors.
• Trading partners.
• Co-members of certain institutions or organisations.
• Strategic allies.
• Nations with similar perceived characteristics.

4. Subjective risk

Subjective risk is not a term that is used everywhere, but it measures factors that are common to most risk assessments – and could greatly impact foreign business owners trading with a host nation. Subjective risk is about attitudes, and can include social pressures and consumer opinions – whether to certain types of goods or certain types of enterprise.  

5. Economic risk

Economic risk encompasses a wide range of potential issues that could lead a country to renege on its external debts or that may cause other types of currency crisis (i.e. recession). A major factor here is economic growth – the health of a nation's GDP and the outlook for its future. For instance, if a country relies on a few key exports and the prices for these are dropping, this creates a negative outlook and may increase the economic risk for foreign trading partners. Acts of government may also impact economic risk, such as intervention in the money market or policy changes that cause tax instability. One other factor is issues with foreign currency exchange, for instance a shortage in certain currencies or a devaluation of the exchange rate.

Exchange risk

Any predicted loss created by sudden changes in exchange rate are generally covered under the exchange risk factor. This is another all-encompassing term as fluctuations in the foreign exchange can be caused by a wide variety of factors. Economic and political factors such as those mentioned above can be significant drivers of exchange risk, although currency reserves, interest rates and inflation are also potential factors.

7. Transfer risk

The final country risk assessment factor we'll discuss today is transfer risk. This is where the host government becomes unwilling or unable to permit foreign currency transfers out of the nation. Sweeping controls such as these may be a side effect of a nation in crisis attempting to prevent creditor panic turning into significant capital outflow.

Ratios that can estimate the financial health of an economy

>Working Capital Ratio

>Quick Ratio

>Earnings per Share

>Price-Earnings Ratio

>Debt-Equity Ratio

>Return on Equity

>Other Liquidity Ratios

Determinants of bond market size: The size of a country plays an important role in determining whether it operates a securities exchange (Clayton, Jorgensen, and Kavajecz, 2006). A literature survey suggests that this is also applicable to bond markets. Countries with less developed or non-existent domestic bond markets are in general small countries. And countries with small financial markets tend to have small bond markets. The correlation coefficient between the ratios of international bond to GDP and private credit to GDP has a value of 35%. However, small countries can overcome the size constraint and develop bond markets by issuing bonds in foreign countries and foreign currencies, or by developing common securities exchanges and spreading the infrastructure costs among members.