Question

Assume you are the economist for a MNC and your job is to keep the CFO and CEO abreast of events affecting country risk. Please comment on one event occurring in the market that may affect country risk that your boss should be aware of and understand. Your job is to make him or her look smart.

Answer 1

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.

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 todefault? 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.

Country risk is a concern because political and economic unrest create volatility. In turn, investors demand higher returns as compensation for this added risk. As you can imagine, Canada would have much less country risk than Nigeria, but in exchange for this peace of mind, Canadian bonds will yield less than the Nigerian bonds. As a result, the presence and degree of country risk makes it more expensive for many emerging economies or struggling countries to borrow money.