Country Risk: Determinants, Measures And Implications – The 2015 Edition

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Aswath Damodaran

New York University - Stern School of Business

July 14, 2015


As companies and investors globalize, we are increasingly faced with estimation questions about the risk associated with this globalization. When investors invest in China Mobile, Infosys or Vale, they may be rewarded with higher returns but they are also exposed to additional risk. When Siemens and Apple push for growth in Asia and Latin America, they clearly are exposed to the political and economic turmoil that often characterize these markets. In practical terms, how, if at all, should we adjust for this additional risk? We will begin the paper with an overview of overall country risk, its sources and measures. We will continue with a discussion of sovereign default risk and examine sovereign ratings and credit default swaps (CDS) as measures of that risk. We will extend that discussion to look at country risk from the perspective of equity investors, by looking at equity risk premiums for different countries and consequences for valuation. In the final section, we will argue that a company’s exposure to country risk should not be determined by where it is incorporated and traded. By that measure, neither Coca Cola nor Nestle are exposed to country risk. Exposure to country risk should come from a company’s operations, making country risk a critical component of the valuation of almost every large multinational corporation. We will also look at how to move across currencies in valuation and capital budgeting, and how to avoid mismatching errors.

Country Risk: Determinants, Measures And Implications - The 2015 Edition - Introduction

Globalization has been the dominant theme for investors and businesses over the last two decades. As we shift from the comfort of local markets to foreign ones, we face questions about whether investments in different countries are exposed to different amounts of risk, whether this risk is diversifiable in global portfolios and whether we should be demanding higher returns in some countries, for the same investments, than in others. In this paper, we propose to answer all three questions.

In the first part, we begin by taking a big picture view of country risk, its sources and its consequences for investors, companies and governments. We then move on to assess the history of government defaults over time as well as sovereign ratings and credit default swaps (CDS) as measures of sovereign default risk. In the third part, we extend the analysis to look at investing in equities in different countries by looking at whether equity risk premiums should vary across countries, and if they do, how best to estimate these premiums. In the final part, we look at the implications of differences in equity risk premiums across countries for the valuation of companies.

Country Risk

Are you exposed to more risk when you invest in some countries than others? The answer is obviously affirmative but analyzing this risk requires a closer look at why risk varies across countries. In this section, we begin by looking at why we care about risk differences across countries and break down country risk into constituent (though inter related) parts. We also look at services that try to measure country risk and whether these country risk measures can be used by investors and businesses.

Why we care!

The reasons we pay attention to country risk are pragmatic. In an environment where growth often is global and the economic fates of countries are linked together, we are all exposed to variations in country risk in small and big ways.

Let’s start with investors in financial markets. Heeding the advice of experts, investors in many developed markets have expanded their portfolios to include nondomestic companies. They have been aided in the process by an explosion of investment options ranging from listings of foreign companies on their markets (ADRs in the US markets, GDRs in European markets) to mutual funds that specialize in emerging or foreign markets (both active and passive) and exchange-traded funds (ETFs). While this diversification has provided some protection against some risks, it has also exposed investors to political and economic risks that they are unfamiliar with, including nationalization and government overthrows. Even those investors who have chosen to stay invested in domestic companies have been exposed to emerging market risk indirectly because of investments made by these companies.

Building on the last point, the need to understand, analyze and incorporate country risk has also become a priority at most large corporations, as they have globalized and become more dependent upon growth in foreign markets for their success. Thus, a chemical company based in the United States now has to decide whether the hurdle rate (or cost of capital) that it uses for a new investment should be different for a new plant that it is considering building in Brazil, as opposed to the United States, and if so, how best to estimate these country-specific hurdle rates.

Finally, governments are not bystanders in this process, since their actions often have a direct effect on country risk, with increased country risk often translating into less foreign investment in the country, leading to lower economic growth and potentially political turmoil, which feeds back into more country risk.

Country Risk

Country Risk

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