Kenneth R. Szulczyk
repay the bonds. Finally, the risk premium reflects a borrower’s credit risk. If the borrower is
likely to default on a loan, subsequently, the borrower pays a greater interest rate, compensating
the investor for lending to a risky borrower.
A credit risk is a borrower does not repay the principal and/or interest of a loan.
Consequently, credit-rating agencies measure a borrower’s risk. For instance, Moody's and
Standard & Poor's assign the risk level for corporate and government's bonds with a letter grade.
Thus, a higher grade implies a smaller default risk, and consequently, the bondholders would
earn a lower interest rate.
Analysts and economists measure a country’s risk similarly, applying the same credit rating
rules. Investors earn smaller interest rates for projects and investments in a foreign country with
a higher letter credit grade. Consequently, a project's rate of return is the country's risk plus the
rate of return to a comparable U.S. Treasury security. A comparable financial security has an
identical maturity. Thus, a country's risk influences the interest rate on the debt issued by that
country's government.
For example, we add a risk premium to calculate the yield on Mexican government bonds.
In this case, the risk premium reflects the creditworthiness of the Mexican government and not
the country’s risk for investing in Mexico. A country's risk embodies an entire country's legal
and economic environment while this example only applies to the Mexican government.
Accordingly, the yields on Mexican government debt should equal the return of a comparable
U.S. government security plus a risk premium. Furthermore, a credit-rating agency rated the
Mexican government a letter grade of BBB that equals a spread of 140 basis points (bps).
Spread becomes the risk premium, and the 140 basis points equal 1.40%, or 140 ÷ 100. If a
comparable U.S. government bond has a 4% interest rate, subsequently, the yield for a
comparable Mexican bond would be 5.40%, or 4% + 1.40%.
We show a country’s credit rating and spread in Table 1. As a bond’s maturity lengthens,
the basis points spread rises. Consequently, the investors want an additional reward for waiting
for the longer time. Financial analysts and investors consider a country’s rating of BBB or better
to be “investment grade,” while they rate a BB or lower as “junk.” Usual spread of junk debt
ranges from 400 to 600 basis points over one-year U.S Treasury bills. Range could be extremely
wide with spreads over 2600 basis points.
Country risk reflects the risk to a particular country by virtue of its location. Consequently,
a country's risk differs from a currency exchange rate risk. A country’s risk could be zero, but
that country has a large currency exchange risk. Reverse could happen but occurs rarely. Thus, a
country's risk reflects the negative influences of a country’s economic and political environment.
Financial analysts use qualitative and quantitative approaches to measure country risk.
Qualitative includes a country’s data and experts’ opinions, who are politicians, union members,
and economists. Furthermore, financial analysts monitor local radio, TV, newspapers, and
embassy publications for information. Unfortunately, expert opinions are subjective, but an
analyst can use experts' consensus to obtain a credit grade. Analysts would consider a country's
historical stability and political turmoil. On the other hand, the quantitative approach includes a
country’s data, and analysts compute a score from data. Quantitative approach “appears” being
more objective because analysts calculate it from data.