International Finance Assignment No.

2 Exe-MBA (2010-13)

Country Risk

Submitted by: Amit Panday 2010E31 Kaustubh Bhagwat 2010E29 Rahul Dudhe 2010E32 Satish Shinde 2010E34 Neeta Kelkar 2010E25

Contents
Contents..................................................................................................................... 2 Financial Risk.............................................................................................................. 3 Economical Risk.......................................................................................................... 4 Political Risk................................................................................................................ 7 Calculation of Country Risk using Stock Market Data...................................................9

1. Country Risk
Country risk refers to the risk of investing in a country, dependent on changes in the business environment that may adversely affect operating profits or the value of assets in a specific country. The Country Risk can be obtained by multiple factors such as: Financial Risk Economical Risk Political Risk

Financial Risk
Liquidity Risk The risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss. There are two types of liquidity risk: Asset Liquidity (Stock, Money Mkt. Instrument, Govt. Bonds) Funding Liquidity (Pay bills or liabilities) Market Risk Stock Prices Interest Rates Foreign Exchange Rates Commodity Prices Operational Risk Risk arising from execution of a company's business functions. Reputational risk (fraud) Legal risk IT risk

Economical Risk
AMB Country Risk Report- India India country Risk Rating: 4

The Country Risk Tier (CRT) reflects A.M. Bests assessment of three categories of risk: Economic, Political and Financial System Risk. India, a CRT-4 country, has great economic potential due to its large labor force. Growth has been strong, averaging nearly 9% in the years leading up to 2008. After a deceleration in 2008 and 2009, strong growth has returned, with GDP expanding by 10.4% in 2010 and by about 8% in full year 2011, and expectations of continued growth over the next few years.

1.1.1.

Economic Risk: Moderate

 India, worlds 10th largest economy as measured by gross domestic product (GDP). Indias manufacturing industries also contribute to growth, though to a lesser degree than the services sectors. Strong domestic demand maintains Indias strong GDP growth rates. GDP is expected to continue to grow by about 8% per year in the years ahead. Monetary policy has been tight and is likely to remain so into 2012, in light of the positive growth outlook and relatively high inflation.

1.1.2.

Financial System Risk: High

The insurance industry is regulated by the Insurance Regulatory and Development Authority (IRDA). The Indian government is working to align its regulatory and accounting standards with international best practices. In 2010, the government formed a Financial Development and Stability Council (FDSC) that will coordinate the efforts of the financial sector regulators in India. Capital markets are relatively illiquid and foreign participation is limited.

1.1.3.

Political Risk: High

Income disparity in India is significant, as approximately one third of the population lives in poverty. National security has become a focus in India, as some of the major cities have been the scene of terrorist bombings. The bilateral relationship with Pakistan is strained. Peace talks have resumed in 2011, but little substantive progress has been made. Some progress on ant-corruption reform has been made in the wake of protests, but it is still considered insufficient by many.

Political Risk
1.1.4. Political Risk Factor: It is the Likelihood that government or bureaucratic inefficiencies, societal tensions, inadequate legal system, or international tensions will cause adverse developments for an insurer or investor. Political risk comprise the stability of the government and society, the effectiveness of diplomatic international relationships, reliability and integrity of the legal systems and of the business infrastructure, the efficiency of the government bureaucracy and the appropriateness and effectiveness of the governments economic policies. 1.1.5. Political Risk Summary: It is a radar chart that display scores for nine different aspects of political risk scored on scale of 1-5 with 1 being the least amount of risk and 5 being the highest amount of risk. CATEGORY International policy DEFINATION

transactions Measures the effectiveness of the exchange rate regime and currency management Measures the ability of a country to effectively implement Monetary Policy Measures the ability of a country to effectively implement Fiscal Policy Measures the overall quality of the environment and ease of doing business business

Monetary Policy Fiscal Policy Business environment Labor flexibility

Measures the flexibility of the labor market, including the companys ability to hire and fire employees. Measures the degree of stability in a government Measures the degree of social stability including human development and political rights Measures the degree of stability in the region Measures the transparency and level of corruption in the legal system

Government stability Social stability Regional stability Legal system

1.1.6. Political Risk Summary Highlights for India with

comparison against US and Libya

The political risk summary for three Country India, US and Libya was studied to understand the effect of all the nine aspects of political risk. As per the A.M. Bests country risk Tiers, all countries are placed into one of five tiers ranging from CRT-1 denoting stable environment with the least amount of risk to CRT-5 denoting countries that pose the most risk. Cou ntry U.S.A. Country Risk Tier CRT-1 Definition Predictable and transparent legal environment, legal systems and business infrastructure, sophisticated financial system regulation with deep capital markets, mature insurance industry framework, Relatively unpredictable and non-transparent legal environment, legal systems and business infrastructure, with underdeveloped capital markets, partially to fully inadequate regulatory structure. Unpredictable and opaque political, legal and business environment with limited or non-existent capital markets, Low human development and social instability; nascent insurance industry.

India

CRT-4

Libya

CRT-5

Calculation of Country Risk using Stock Market Data

1.1.7. Spread in 10 year government bond:
The simplest and most widely used measure of country risk comes from looking at the yields on bonds issued by the country in a currency (such as the dollar or the euro) where there is a default free bond yield to which it can be compared. The yield spread is the difference between the quoted rates of return on two different investments, usually of different credit quality. When spreads widen between bonds with different quality ratings it implies that the market is factoring more risk of default on lower grade bonds. A narrowing of spreads between bonds of different risk ratings implies that the market is factoring in less risk due to an expanding economy. The yield spread analysis also helps investors and interested people understand the markets trend when it comes to various investment instruments. When the spread is wide between bonds of different quality ratings, the investors can conclude that the market is factoring more risk of default on the lower grade bonds, which implies that the economy is slowing down and thus that the market is predicting a greater risk of default. The bond spread is subject to volatility and therefore we should take the average of bond

spread over a period of time. For our analysis we have taken ot for a period of 3 months April 2012 to June 2012. Analysts add default spreads as measures of country risk typically add them on to both the cost of equity and debt of every company traded in that country. The below graph shows volatility in four countries for 10 year government bond yields for a period of April 2012 to June 2012. The volatility in spreads is measured by considering US as the base.

We will compare spread between 10 year government bond issued by RBI in India, 10 year US bond, 10 year Brazil bond and 10 year Greece bond. The relative volatality for the countries is measured by taking the average of data for the period under analysis and considering US as the base. The below graph shows the relative volatality of India, Brazil and Greece considering US as base.

1.1.8.

Relative Equity Market Standard Deviations:

This approach is based on assumption that the equity risk premiums of markets should reflect the differences in equity risk, as measured by the volatilities of these markets. A conventional measure of equity risk is the standard deviation in stock prices; higher standard deviations are generally associated with more risk. If we scale the standard deviation of one market against another, we obtain a measure of relative risk. Relative Standard Deviation (Country Y) = Standard Deviation (Country Y) Standard Deviation (Country X) This relative standard deviation when multiplied by the premium used for Country X stock yields a measure of the total risk premium for any market. Equity Risk premium (Country Y) = Risk Premium (Country X) * Relative Standard Deviation (Country Y) Once the Equity Risk Premium has been found out the country risk premium can be found out as follows: Country Risk Premium (Country Y) = Equity Risk premium (Country Y) - Risk Premium (Country X) For our analysis, we collected data for closing prices of US, India, Brazil and Greece stock indices from April 2011 to March 2012 on weekly basis. Then we calculated the standard deviation of the returns of the stocks. Then we

calculated relative standard deviation of India, Brazil and Greece considering US as base. The below graph shows the relative standard deviation of above countries as calculated above. More the relative standard deviation, more risky is the country.

BSE Sensex India; BOVESPA Brazil; ATHEX Greece

1.1.9.

Calculation of Country Risk Premium

The additional risk associated with investing in an international company rather than the domestic market. Macroeconomic factors such as political instability, volatile exchange rates and economic turmoil causes investors to be wary of overseas investment opportunities and thus require a premium for investing. The country risk premium (CRP) is higher for developing markets than for developed nations. Thus, a portfolio manager who decides to pull out of the stock market because he feels stocks are over priced is telling you that he thinks that equity risk premiums will increase in the future. The equity risk premium reflects fundamental judgments we make about how much risk we see in an economy/market and what price we attach to that risk. In the process, it affects the expected return on every risky investment and the value that we estimate for that investment. A conventional measure of equity risk is the standard deviation in stock prices; higher standard deviations are generally associated with more risk. If you scale the standard deviation of one market against another, you obtain a measure of relative risk.

 For instance, the relative standard deviation for country X (against the US) would be computed as follows: Relative Standard DeviationCountry X =Standard DeviationCountry X/Standard DeviationUS If we assume a linear relationship between equity risk premiums and equity market standard deviations, and we assume that the risk premium for the US can be computed (using historical data, for instance) the equity risk premium for country X follows: Equity risk premiumCountry DeviationCountry X X = Risk PremumUS*Relative Standard

Country risk Premium X= ERP X ERP US

EQUITY MARKET VOLATILITIES AND RISK PREMIUMS(FEB 10-12) COUNTRY S. D. Country S.D. U.S. Relative S.D. ERP country% Country risk prem% % % s.d. country/s.d. US (Risk prm.us)*relative sd ERPcal-ERPus CHINA INDIA ITALY US PHILLIPINES PORTUGAL VIETNAM 0.22 0.1987 0.2996 0.1955 0.1835 0.2046 0.2542 0.195500 0.195500 0.195500 0.195500 0.195500 0.195500 0.195500 1.13 1.02 1.53 1.00 0.94 1.05 1.30 6.751918159 6.098209719 9.19488491 6 5.631713555 6.279283887 7.801534527 0.75 0.10 3.19 0.00 -0.37 0.28 1.80