Country Risk Management in Global Financial MarketsAlina Sachapow, Gloria Armesto & Navi Phifer

20 Dec 2011

Country risk refers to the economic, political and business risks that are unique to a specific

country and might result in unexpected investment losses. There are many ways to avoid or at least

minimize possible complications related to country risk. Diversification of investment and types of

securities is the best way to protect a portfolio from being seriously affected by negative events.

The term diversification describes “a risk management technique that mixes a wide variety of

investments within a portfolio.”1 This is aimed at reducing the risk of an investment in order to

stabilize or increase the return on it.

The most important thing to do before investing anywhere is a thorough analysis of the

markets and the countries an investor plans to go to. Only when knowing the risks and opportunities of

the specific securities and countries, it is possible to find the right investment and diversification

strategy. In the case of Japan we found out that it has a high contagion risk that leads to a certain

market hazard, a high risk of natural disasters, and an imminent sovereign peril, whereas Brazil is

rather facing political, inflationary and transfer risks. A well-diversified investor can utilize this

information to develop a wise diversification strategy.

The first choice concerning diversity of investment is deciding where to invest. There are three

types of markets to choose from: Firstly, developed markets consist of the largest, most industrialized,

politically stable economies. These markets are considered the safest for investments. Japan, France

and Canada enter under this category. Emerging markets experience rapid industrialization and often

demonstrate extremely high levels of economic growth. These markets are riskier than developed

markets and have more political uncertainty. Under this category are Brazil, China and India. Lastly,

frontier markets are usually smaller than emerging markets and can be very risky and have low levels

of liquidity, but they offer the potential for above average returns over time. Examples of frontier

markets include Nigeria and Kuwait.

An investor can choose to invest entirely in a specific region like Europe, or entirely in a

specific country, but this wouldn’t be prudent. The reason is that not every risk can be diversified. The

risk that actually can almost be eliminated is called unsystematic risk. It is attributed to a certain

company or industry. Systematic risk is harder to avoid because it includes country risks that cannot

be controlled by the markets as the inflation rate, exchange rate, political risk, or the peril of natural

catastrophes. If an investor chooses to only invest in one country these country specific systematic

risks cannot be overcome.2 Therefore investors can decide to invest in several countries to convert the

systematic risks of certain countries into unsystematic risk that can be diversified with the help and

different situation of other countries. Diversification works best when the returns of the single

investments are negatively correlated. This is why it makes sense to invest in different countries to

1 http://www.investopedia.com/terms/d/diversification.asp#axzz1h1Dl6Wke accessed on 20 Dec 20112 “Fundamentals of Corporate Finance”, Brearley, Myers, Marcus, 6th Ed. Chapter 11, page 328

Country Risk Management in Global Financial MarketsAlina Sachapow, Gloria Armesto & Navi Phifer

20 Dec 2011

equal out the risks that evolve.3 So, if, for example, Japan has a high risk of contagion and Brazil does

not, it is advisable to invest in both the countries to reduce the impact that Japan’s contagion risk has.

Therefore it is better to spread investment among developed, emerging and perhaps frontier

markets to maximize diversification and minimize risk.

The second important choice to make is what investment vehicles to invest in. The investor

should allocate among short-term and long-term securities as different maturities represent a different

level of risk: stocks, bonds, treasury bills, commercial papers, mutual funds, etc. The choice depends

mostly on investor’s individual knowledge, experience, risk profile and return objectives. There are

many different stock valuation methods available, falling under the category of fundamental or

technical analysis, that are used to forecast an industry’s or company’s future performance. The Price-

Earnings (PE) method, Dividend Discount model, Capital Asset Pricing Model (CAPM) and even the

Arbitrage Pricing model all have their own unique shortcomings and failures, but can help to create a

good investment strategy.4

An example of a diversified portfolio could be buying government bonds in Brazil (emerging

market), commercial papers from an AAA-rated company in Japan and stocks from a company in

France. In this way, the investor can avoid credit risk with the government bonds and receive a risk

premium from the stocks in France. Since France is a developed market, the risk of default, the

political and economic risk are very low. On the other hand, Japan is also a developed market, but has

a high economic risk due to its vulnerability to natural disasters and a high contagion risk since it is

also vulnerable to falls and rises in global demand. That is why it could be a better idea to invest in the

money market, since the risk is lower in the short-term.

There are a variety of ways in which a business or private investor can diversify their portfolio

in order to alleviate certain risks inherent to a specific country’s role in global financial markets.

Citigroup, for example, offers local currency funding and foreign exchange transactions to counter

exchange rate risk as well as cash management services to counter a country’s sovereign risk, to name

a few.5 Within the stock market, there are also certain regulations in place to maintain order and ensure

adequate liquidity. Organized exchanges such as the New York Stock Exchange (NYSE) have

minimum requirements of outstanding shares, earnings and cash flow during recent periods. Agencies

regulating trade in over-the-counter markets such as the National Association of Securities Dealers

Automatic Quotations (Nasdaq) have recently been merging with their on-the-floor counterparts in

order to ensure less discrepancy between regulations in the different markets.6

3 “Fundamentals of Corporate Finance”, Brearley, Myers, Marcus, 6th Ed. Chapter 11, page 3244 „Financial Institutions & Markets“, Madura, 9th Ed. Chapter 11. Stock prices may be affected by country risks such as economy and market.5 Ibid, Ch. 17 pg 478.6 Ibid, Ch. 10 pg 244.

Country Risk Management in Global Financial MarketsAlina Sachapow, Gloria Armesto & Navi Phifer

20 Dec 2011

A third method used to counter exposure risk to movements in security prices is hedging,

investing in Derivative Securities (DS) such as futures, forwards, and options. 7 DS can be used in a

manner that will generate gains if the value of the underlying asset declines, such as taking a futures

position to sell securities at a certain fixed price in the future, regardless of the actual market price at

the date of sale. DS can be used to reduce market exposure to interest rate risk, unexpected industry

“bubbles” and also unforeseen factors such as natural disasters which is worth considering in the case

of Japan. Though DS can be helpful in reducing risk, an investor should take caution of this double-

edged sword being used to also drive up stock prices far higher than their fundamental prices.8

Last but certainly not least, an international investor needs to constantly monitor their portfolio

and adjust as conditions change. Even the risk-free rate can be affected by several factors, such as

inflationary expectations, economic growth, money supply growth and budget deficit. Situations that

once seemed promising and safe may no longer be so and countries that once seemed too risky might

now be viable investment candidates. Though there are a wide variety of methods and options used

today to manage country risk in global financial markets, none of them are one hundred percent

accurate. An investor should always keep this in mind when “gambling” with international financial

markets.

7 Ibid, Ch. 13 pg 325.8 Ibid, Ch. 14 pg 378