Building bridges: From the probability of a country crisis to a country risk assessment

Abstract

Country risk is often misconceived, leading to misunderstanding and, consequently, misapplication. This paper aims to provide an alternative way to assess country risk, based on quantitative tools where the link between country crises, firms’ characteristics and country risk ratings are presented. This paper reviews the literature on country risk concepts and develops a theory for the impact of country risk on the real economy, in particular how the outcome, provoked by a country crisis, effects firms’ assets. A statistical model based on the probability of a crisis adjusted to firm idiosyncratic exposure to country risk is built with respect to the type of exposed asset. The proposed assumptions that country risk alone does not exist, and that country risk must be combined with the primary source of risk to be measured, are rooted in natural science concepts about vulnerability and hazard and are the essence of this paper. The model is forward looking based on the probabilities of the occurrence of countries’ crises, providing an economic foundation for the additional cost of capital that country risk represents. This methodology could provide additional help to investors and banks.