Home / Summaries / Class notes - Part 4: Valuation and Risk Models / risk-default-cds

Country Risk

6 important questions on Country Risk

Why do we care about country risk?

Diversification has provided some protection against some risks, it has also exposed investors to political and economic risks that they are unfamiliar with, including nationalisation and government overthrows (Shell in Nigeria). Also in domestic companies, investors are indirectly exposed to the foreign investments.

What about measuring country risk?

Have composite measures of risk that incorporate all types of country risk. Problem is that audience or perspective is mostly different. Factors like:
- Corrpution
- Government effectiveness
- Political stability
- Regulatory quality
- Rule of law
- Voice/accountability

Limitation however:
- Measurement models/methods, little relevance
- No standardisation, differ extensively by own protocol
- More ranking than score, ranking says more than the score. A double score does tell that there is double amount/exposure to a risk.

Sovereign default risk?

Most direct measure of country risk is a measure of default risk when lending to teh government of that country. MEthods:
- Rating
- Sovereign bond market rate spread
- CDS premium

What are the short and long terms effects of defaulting on debt?

- NEgative impact on GDP of 0.5% tot 2%
- It affects a country's long term sovereign rating and borrowing costs, o.5 to 1% higher.
- Sovereign default can cause trade retaliation, drop of 8% in bilateral trade
- Make banking systems more fragile, 14% PD instead of 3%
- Increases the likelihood of political change
Default is costly, particularly when it involves a banking crises.

How about measuring sovereign default risk?

Need it to set interest rates but also to price a lot of other assets.

What about credit default swaps?

The price of these contracts represent market assessment of default risk in countries updated constantly. Can be physical or cash settlement. But:
- Only triggered by credit event
- Guarantee is only as good as the guarantor
Corporate CDS much bigger as well as bank CDS.

Problem:
- Narrowness of the market (few players)
- Liquidity and counterparty risk might play a role

Better predictor?
- Lead spread changes and rating changes
- Not better or quicker than bonds
- Clustering in CDS market (move together, 6 EM clusters)

But undeniable that CDS provides important information, but little to indicate it is superior.

The question on the page originate from the summary of the following study material:

Part 4: Valuation and Risk Models

View summary