Country Risk Definition & Samples

DailyForex.com Team

What is Country Risk - Defined

The global financial system offers countless opportunities to market participants who can access assets issued by companies and governments from many countries via their online brokers. Country risk is often ignored, given the availability of trading instruments. We will provide the country risk definition and explain why a country risk assessment is necessary to lower avoidable losses.

What is Country Risk and Why it Matters

Country risk refers to the risk of investing in the financial assets of a country. More precisely, it relates to the risk of financial losses due to uncertainty about the financial and economic health of a country, exposing its assets to volatility that may result in avoidable losses for market participants.

When conducting a country risk analysis, consider the following aspects:

  • Existing domestic economic conditions
  • Commercial risks to international trade
  • The health of the financial system
  • Monetary policy and sovereign debt
  • The political climate
  • A structural assessment
  • Domestic currency trends

Country risk is closely related to sovereign risk, or the ability of the country to meet financial obligations. Every government issues bonds used to finance operations which are easily accessible. Rating agencies provide a country risk rating, but it is a lagging indicator, and rating agencies are known to act slowly. For example, a missed bond payment could result in contagion, ripple through the markets, and investors face losses.

Domestic companies, who issue equities and bonds, which traders and investors add to portfolios, are exposed to country risk. Entities operating in less risky countries usually perform better than those in higher-risk environments. While opportunities exist everywhere, not every investor can accept associated risks. A country risk level assessment will help with appropriate asset selection if measured against their risk profile and available capital.

An in-depth country risk assessment can highlight investment opportunities to avoid, as they are outside acceptable risk parameters. A country risk index can help beginner traders navigate international trading opportunities. Country risk management is part of portfolio risk management. Many beginners ignore it, as they believe if a broker lists the asset, it must be safe to trade, which is not always the case.

What Should You Know About Country Risk?

Developed nations usually have lower country risk than developing countries. The risks increase for emerging markets, and frontier markets face the most substantial risk. Political and economic instability remain the primary factors that elevate country risk. They filter through the domestic financial system and impact entities issuing securities that professional and retail clients add to their portfolio, seeking attractive returns.

The higher the country risk, the more notable the impact on the expected return on investment (ROI), and the higher the opportunity and portfolio risks. It impacts the stability of domestic assets but also affects foreign companies doing business in higher-risk countries, as their financial stability will feel a negative impact should unfavorable events materialize.

Market participants can hedge against some elements of country risk, like Forex fluctuations, but there is no hedge for political risk. A sovereign debt analysis often includes all moving parts that impact country risk, conducted by companies to create country risk classifications. Foreign direct investments, conducted by entities directly into a country rather than through a regulated market or exchange, face the highest exposure to country risk.

Two Country Risk Examples

The below examples of country risk give investors an idea of scenarios to consider when creating a country risk management strategy as part of their overall risk management.

Country risk example one:

  • An investor analyzes assets in the US and Argentina for a bond investment
  • Given the high debt load of Argentina, it makes any investment riskier
  • Since the US ranks among low-risk countries, bond yields are low, meaning investors will earn less money but also do not have to worry about default, a primary counterparty risk
  • Argentina will have higher yields, compensating investors for the additional risks
  • It increases borrowing costs for countries that require funding to improve their conditions, which could lower their risk profile

Country risk example two:

  • An investor considers buying shares in a UK-listed company, which ranks among the most secure markets globally
  • The UK-based company has 60% of its business exposure in Nigeria
  • The investor must consider the country risk of Nigeria and not rely solely on the UK listing, as a material issue in Nigeria will crush the share price of the UK-listed company

Advertisement
Trade with a top-rated
Nigerian broker now!

Trade Now!

Which Country Risks Must International Businesses Consider?

International business ventures offer many opportunities but also carry additional risks. The most notable ones are economic, fiscal, political, or social risks. A what is country risk understanding is necessary before conducting a country risk analysis.

Sovereign debt ratings can help investors navigate country risk when considering bonds, but a more detailed analysis remains mandatory for equity investments. Below are risk factors investors should consider when analyzing financial instruments and conducting a business analysis of international companies.

Economic risks:

  • Government finances
  • GDP outlook
  • Current account and trade balance
  • Bank stability and solvency
  • Monetary policy
  • Forex rates and foreign capital reserves
  • Affordability and access to capital by the government and companies
  • Unemployment rate
  • Inflation and wage data
  • Consumer spending and confidence

Fiscal risks:

  • Sovereign debt management and interest payments
  • Corporate debt and access to capital
  • Consumer debt and default rates
  • Debt-to-GDP ratio
  • Interest rate environment and outlook

Political risks:

  • Stability of the government and influence of politicians or political parties
  • Access to verifiable information and transparent reporting
  • Data on violence, crime, and terrorism
  • The regulatory and policy environment and if it hinders growth or protects expansion
  • The capability, freedom, and mobility of the domestic workforce
  • Government programs and subsidies for businesses
  • Attitude and acceptance of foreign direct investment with transparent capital flows
  • Legal environment governing Immigration and employment

Social risks:

  • Overall demographics and labor force composition
  • Commercial and social infrastructure
  • Access to higher education and its affordability
  • The import and export environment, rules, and regulations
  • International treaty and trade pact memberships with an opportunity for cross-border collaboration
  • Intentional Government and corporate competition

How to Conduct a Country Risk Assessment

Investors can access numerous qualitative and quantitative tools to conduct a country risk assessment. A quantitative risk assessment consists of ratios, statistics, and algorithms to create country risk classifications and a detailed country risk rating.

Some tools investors can use to complete a country risk assessment are:

  • Political and business news
  • Economic indicators, analytics, and news
  • Statistical indicators
  • Trustworthy international firms that conduct objective country risk analysis for clients
  • Rating agencies and their outlooks
  • Global asset management firms and their published sovereign debt assessments, country analysis, and view on country risk management
  • Correlation and beta coefficients from various indices

Country Risk Ratings

Rating agencies constantly evaluate and rate sovereign debt, while asset managers and international firms create indices and ratings based on their models. While not always accurate and often late to account for rapid changes, they serve as a benchmark for many professional portfolio managers and investors.

Since most data is public, seasoned investors should conduct their country risk assessment. They can include data published by rating agencies but with added objectivity and fine-tuned to individual risk profiles. Most country ratings remain biased, hence their poor track record in identifying future risks.

Country Risk Conclusion

Country risk management fulfills a crucial role with international investments, as they directly impact the outcome of any investment. Investors can hedge against a few risks, namely Forex and interest rate risk, but most aspects of country risk, for example, economic, political, and social, are hard to predict.

Foreign direct investments carry the highest degree of country risk, closely related to sovereign risk. Higher-risk countries offer better yields and higher income potential to compensate investors for the additional risks they accept. It also makes borrowing costs for those in need more expensive.

FAQs

Why is country risk important?

Economic, political, and social unrest creates volatility, making country risk an essential parameter to consider. Investors demand higher returns in exchange for added risk, which increases costs for the issuing country, and potentially magnifies risks.

What is country risk management?

Country risk management is the country risk assessment from an investment respective, ensuring deployed capital meets internal risk profiles.

How can we prevent country risk?

An objective country risk assessment, diversification, and segregation of investments are three primary means to lower country risk. Preventing country risk is only possible by not investing.

DailyForex.com Team
The DailyForex.com team is comprised of analysts and researchers from around the world who watch the market throughout the day to provide you with unique perspectives and helpful analysis that can help improve your Forex trading.

Did you like what you read? Let us know what you think!

exclamation mark

Please make sure your comments are appropriate and that they do not promote services or products, political parties, campaign material or ballot propositions. Comments that contain abusive, vulgar, offensive, threatening or harassing language, or personal attacks of any kind will be deleted. Comments including inappropriate will also be removed.

0 User comments

exclamation mark

Please make sure your comments are appropriate and that they do not promote services or products, political parties, campaign material or ballot propositions. Comments that contain abusive, vulgar, offensive, threatening or harassing language, or personal attacks of any kind will be deleted. Comments including inappropriate will also be removed.

Read more
Add new comment
This site is protected by reCAPTCHA and the Google Privacy Policy and Terms of Service apply.