A Simple Approach to Country Risk

Abstract

It had been a widely held belief that the debt crisis of the 1980s was over when the Mexican crisis at the end of 1994, the Asian crisis in 1997, and the Russian crisis in 1998 made clear that highly indebted developing countries remain vulnerable. Hence, investment in such countries is still risky and should be assessed properly. A definition of country risk is as follows of the Basel Committee (1999)[p.7]: “g or sovereign risk encompasses the entire spectrum of risks arising from the economic, political and social environments of a foreign country that may have potential consequences for foreigners debt and equity investments in that country”. Note that two markets are mentioned. This paper focusses on the link between these markets. This paper is not concerned with predicting crises. With respect to forecasting there is ample literature available which was recently reviewed by Somerville and Taffler (1995) and Kaminsky, Lizondo and Reinhart (July 1997). Furthermore there is the issue of risk dependencies between different countries that has been emphasized recently of the Basel Committee (1999)[p.7]: “Banks need to understand the globalisation of financial markets and the potential for spillover effects from one country to another”. In order to adress this issue as well recent techniques from derivative pricing are applied assuming that market prices of a country’s external debt are derived from the prices of other liquid financial instruments. The approach chosen allows the integration of “market and credit risk” and enables portfolio-wide assessment of country risk incorporating correlations.