What Is Country Risk In Investment?
Country risk, also called political risk, is the uncertainty of returns caused by the possibility of a major change in the political or economic environment of a country. The United States is acknowledged to have the smallest country risk in the world because its political and economic systems are the most stable.
Nations with high country risk include Russia, because of the several changes in the government hierarchy and its currency crises during 1998, and Indonesia, where there were student demonstrations, major riots, and fires prior to the resignation of President Suharto in May 1998.
In both instances, the stock markets experienced significant declines surrounding these events.8 Individuals who invest in countries that have unstable political economic systems must add a country risk premium when determining their required rates of return.
When investing globally (which is emphasized throughout the book), investors must consider these additional uncertainties.
How liquid are the secondary markets for stocks and bonds in the country? Are any of the country’s securities traded on major stock exchanges in the United States, London, Tokyo, or Germany?
What will happen to exchange rates during the investment period? What is the probability of a political or economic change that will adversely affect your rate of return?
Exchange rate risk and country risk differ among countries. A good measure of exchange rate risk would be the absolute variability of the exchange rate relative to a composite exchange rate.
The analysis of country risk is much more subjective and must be based on the history and current environment of the country. This discussion of risk components can be considered a security’s fundamental risk because it deals with the intrinsic factors that should affect a security’s standard deviation of returns over
time.
In subsequent discussion, the standard deviation of returns is referred to as a measure of the security’s total risk, which considers the individual stock by itself—that is, it is not considered as part of a portfolio.
Risk Premium = f (Business Risk, Financial Risk, Liquidity Risk, Exchange Rate Risk, Country Risk)
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