Cross-border investment involves different undiversifiable risks, among which the country risk is one of the most significant as it is closely interrelated with the business risk. High country risk results in high business risk, which in turn discourages an investor to invest. Therefore a cross-border investment is highly depended on the country risk of the investment country. Many researchers argue that country risk must be compensated with additional premium, as failure to include a justified country risk premium into the investment valuation would misrepresent its value. In the previous assignments, we suggested an investment in the United Kingdom (UK) so it is required that we calculate a valid country risk premium to adjust the investment value.
Every company is not equally exposed to the same country risk as each firm has a different operating strategy (Damodaran, “Measuring Company Exposure” 2). Damodaran suggested two different approaches with the help of which the country risk premium can be measured: the historical premium approach and implied premium approach (“Measuring Company Exposure” 5). The historical risk premium approach uses the past data of return of stock and bond of a country to estimate its risk premium. However, Damodaran proved that historical data usually do not reflect the actual measurement because the value is derived from return on stocks and bonds over time and these values are highly volatile (Damodaran, “Measuring Company Exposure” 5-6). The alternative approach of risk premium calculation uses financially estimated data and does not require historical data; however, the approach suggests that there is no need to calculate country risk to estimate the total risk premium (Damodaran, “Measuring Company Exposure” 13). Since we need to calculate the country risk of the United Kingdom, we will quantify the country risk premium using the historical premium approach suggested by Damodaran. The approach will be employed for several reasons the most important of which is the availability of information. Another factor that we can consider is to categorize the host country based on the rating score: as low risk, medium risk, and high-risk country. According to International Country Risk Guide a country risk can be categorized by evaluating 22 different variables to score the country based on political risk, economic risk, and the financial risk of the country (Howell). Different sources suggest that the UK has an ICRG rating of 80-82 in the last five years and therefore it can be considered as a low-risk country. Logically, there should be a meager or no country risk premium associated with the proposed investment (“Regional Political Risk Index”). Measuring the political risk, the financial and economic risk of a country is important as these risks significantly affect the return of investment into a foreign country (Hayakawa et al. 1-4). Hayakawa et al. also mentioned that financial risk and economic risk do not have a considerable positive impact on the return but the political risk greatly affects the investment into a foreign country. As the ICRG rating is suggesting that the United Kingdom (UK) is a low-risk country so investment in the country should have a little or no undiversifiable (political, economic, and financial) risk. In order to be more precise in estimating country risk, we will estimate it with the help of the quantifying approaches in the relevant literature.
The very first approach is the credit rating of the country assigned by different sovereign credit rating agencies (Moody’s). Moody’s rating states that the UK has a rating of Aa1, while S&P ranks the credit rating of UK as AAA (“Sovereign Ratings List”). Based on the sovereign credit rating it can be assumed that the country risk premium should be near to zero or very insignificant in order to make an investment decision. But it is rather a measure of country default risk rather than equity risk (Naumoski 8). Moody’s failed to update the regular credit ratings of countries. For instance, in the case of India Moody’s didn’t update its rating since 2004-2007 though the country had a substantial economic growth in the period. Therefore, it makes the rating ineffective (Damodaran, “Equity Risk Premiums” 43). Furthermore, as quoted in Naumoski “Porras (2011) notes, the ratings provided by the agencies often do not completely reflect expectations about the future, but they have an important historical component (8).”
For calculating the effective country risk Damodaran suggests a new approach of using Moody’s credit rating for the country – calculation of Sovereign Credit Default Swap (CDS), calculation of rating based default spread and calculate the country risk following the approach showed by Damodaran. Using Sovereign bond spread in the calculation incorporating the credit rating score by the sovereign credit rating firms gives a comprehensive measurement of the overall country risk premium. However, the problem of the calculation is the lack of required data for calculating the sovereign bond spread, though in the case of UK there is no such problem. In his writing “Estimating Risk Premium” Damodaran suggested to use credit default swap for measuring country risk as these particular types of security has become very popular. Naumoski agreed that under normal market the sovereign CDS can be a good estimate of the country risk measurement but Revoltella, Mucci, and Mihaljek find that CDS can mislead the country risk calculation approach (10). To avoid such risk of being misguided by the use of CDS the standard approach of using US CDS as the base and then subtracting the UK (the other country) CDS spread the calculation is done. Another thing that can be incorporated into the calculation of the country risk is the equity market volatility, the standard deviation of the equity standard deviation (here the FTSE 100) is taken into consideration for the calculation of the standard deviation of the bond. The calculation takes all the discussed issues into consideration to provide us with an effective calculation of the country risk. The following formula provides an explanation:
(Damodaran, “Equity Risk Premiums” 53).
Following such approach, the data suggest that the adjusted default spreads for the UK is.46%, the total country risk premium is exhibiting 6.25%, and calculation of sovereign CDS.23%. Using the information, the country risk for the UK shows 56%, so if we want to invest in the UK then an additional country risk premium of 56% will have to add on top of the calculated risk premium. The assumptions of the calculation are:
- Moody’s rating is up-to-date and it reflects the exact scenario of the country’s credit rating.
- Country risk is limited to credit market volatility, economic changes but the political impact is not fully quantified in the calculation.
- Damodaran’s method of country risk assessment provides a representative country risk measurement.
In brief, it can be concluded that the UK is the low-risk country for investing and to get the true investment value a country risk premium of 56% will be sufficient for an investment decision in the equity or money market in the country.
Works Cited
Damodaran, Aswath. Measuring Company Exposure to Country Risk: Theory and Practice. 2003, Web.
Damodaran, Aswath. Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2011 Edition. 2011, Web.
Hayakawa Kazunobu, et al. How Does Country Risk Matter for Foreign Direct Investment? 2011, Web.
Howell, Llewellyn D. International Country Risk Guide Methodology. n.d., Web.
Moody’s – Credit Ratings, Research, Tools and Analysis for the Global Capital Markets. Moody’s, 2017, Web.
Naumoski, Aleksandar. “Estimating the Country Risk Premium in Emerging Markets: The Case of the Republic of Macedonia.” Financial Theory and Practice, vol. 36, no. 4, 2012, pp. 413-434.
“Regional Political Risk Index.” PRS Group. 2017, Web.
“Sovereign Ratings List”. Global Credit Portal. 2017, Web.