International Financial

1.        Empirical study (Theoretical Model)

The general country risk model typically estimated, tested and evaluated is given as:

 f (Y_t , X_t , μ_t ;β ) = 0

Where is:

 f (.)      = an unspecified functional form

Y         = the designated (vector of) endogenous variables

X         = the (vector of) exogenous variables

μ          = the (vector of) errors

β          = the vector of unknown parameters

t           = 1,..., n observations.

The equation above is typically given as a linear or log-linear regression model, or as a logit, probit or discriminant model.

2.        Rating agencies

There are some agencies that can be used to evaluate country risk. These agencies are leading commercial analysts of country risk. Some of them are:

1.        Institutional Investor

This agency compiles semi-annual country risk surveys, which are based on responses provided by leading international banks. Bankers from 75-100 banks rate more than 135 countries on a scale of 0 to 100, with 100 representing the lowest risk. The individual ratings are weighted using the Institutional Investor formula, with greater weights assigned to responses based on the extent of a bank’s worldwide exposure and the degree of sophistication of a bank’s country risk model. The names of the participating banks are kept strictly confidential (Howell, 2001). Institutional Investor country risk surveys are published in the March and September issues of the monthly magazine. In the country risk literature, the Institutional Investor country risk assessment is known as the banker’s judgment.

2.        Euromoney

This agency provides semi-annual country risk ratings and rankings. Countries are given their respective scores based on nine components, and are ranked accordingly. In order to obtain the overall country risk score, a weight is assigned to each of the nine categories (political risk, 25%; economic performance, 25%; debt indicators, 10%; debt in default or rescheduled, 10%; credit ratings, 10%; access to bank finance, 5%; access to short-term finance, 5%; access to capital markets, 5%; and discount on forfeiting, 5%). The best underlying value per category achieves the full weighting, while the worst scores zero. All other values are calculated relative to the best and worst scores. Surveys are published in the March and September issues of this monthly magazine.

3.        Moody’s

This agency provides sovereign credit risk analysis for more than 100 nations, virtually every one of which participates in the world's capital markets. For each nation, Moody’s publishes several different types of ratings to capture divergent risks, including country ratings for both short- and long-term foreign currency securities. In establishing country risk, Moody’s analysts assess both political and economic variables to derive country risk ratings, which act as sovereign ceilings or caps on ratings of foreign currency securities of any entity that falls under the political control of a sovereign state (Howell, 2001). Country risk ratings account for foreign currency transfer risk and systemic risk in the nation. Using Moody’s Aaa to C rating scale, foreign currency long-term government bonds and domestic currency long-term government bonds are rated. Local currency guideline ratings, which indicate the highest rating level likely for debt issues denominated in local currency, are also provided.

4.        Standard and Poor’s

This agency provides weekly updates on the credit ratings of sovereign issuers in 77 countries and territories. Sovereign ratings are not country ratings as they address the credit risks of national governments, not the credit risk of other issuers. However, sovereign ratings set the benchmark for the ratings assigned to other issuers in the country. S&P’s provides short- and long-term ratings, as well as a qualitative outlook on the sovereign’s domestic and foreign currency reserves. Ratings are provided for seven major areas, namely long-term debt, commercial paper, preferred stock, certificates of deposit, money market funds, mutual bond funds, and the claims-paying ability of insurance companies. The determination of credit risk incorporates political risk (the willingness of a government to service its debt obligations) and economic risk (the government’s ability to service its debt obligations) (Howell, 2001). Foreign currency issuer ratings are also distinguished from local currency issuer ratings to identify those instances where sovereign risk makes them different for the same issuer. Quantitative letter ratings range from C (lowest) to AAA (highest). The rating outlook assesses the potential direction of a long-term credit rating over the intermediate to longer term. In determining a rating outlook, consideration is given to any changes in the economic and/or fundamental business conditions.

5.        Economist Intelligence Unit

This agency publishes country risk reports that are available quarterly with monthly updates. These reports summarizes the risk ratings for all 100 key emerging and highly indebted countries that are monitored by the Country Risk Service (CRS). The CRS risk rating methodology examines two different types of risk: (1) country risk, as determined by (with weights in parentheses) political (22%), economic policy (28%), economic structure (27%), and liquidity (23%) factors; and (2) specific investment risk. Three different types of specific investment risk are currency risk (associated with accepting foreign exchange exposure against the US (dollar), sovereign debt risk (associated with foreign currency loans to sovereign states), and banking sector risk (associated with foreign currency loans to banks). These specific investment risk ratings are also determined by the same four factors, with different weights. For currency risk, economic policy is the most heavily weighted factor at 65%, with economic structure, political, and liquidity factors having weights of 17%, 14%, and 4%, respectively. In the case of sovereign debt risk, liquidity has the highest weight at 31%, with economic policy and economic structure each being weighted at 27%, and the political factor at 15%. Finally, for banking sector risk, economic structure is the most heavily weighted at 44%, with economic policy, liquidity, and political factors weighted at 35%, 15%, and 6%, respectively

6.        Political Risk Services

This agency provides reports for 100 countries. Each report assesses potential economic, financial and political risks to business investments and trade. Country reports are the only source for risk forecasts and analysis based on the PRS rating system, which assesses different political scenarios. PRS provides a political risk model with three industry forecasts at the micro level, namely financial transfers (banking and lending), foreign direct investment (such as retail, manufacturing, and mining), and exports to the host country market. The 100 reports are revised on a quarterly basis.

References:

Howell, L.D. 2001. The Handbook of Country and Political Risk Analysis, Third Edition. New  York: The PRS Group.

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http://www.prsgroup.com/commonhtml/methods.html