Country Risk in Global Financial Management
Research Foundation of the CFA Institute monograph.
Summary
Erb, Harvey and Viskanta produced this research monograph for the Research Foundation of the Institute of Chartered Financial Analysts, examining whether country risk measures predict investment returns.
The empirical question is specific. Commercial services publish country risk ratings covering political risk, economic risk, financial risk and composite measures, and sovereign credit ratings are published by the rating agencies. The authors test whether these ratings, which are publicly available, contain information about future equity and bond returns across countries.
Their finding is that they do. Countries with higher risk ratings, meaning worse assessed conditions, subsequently delivered higher returns, and the relationship holds after controlling for other factors. They interpret this as compensation: investors require higher expected returns to hold assets in riskier countries, and the ratings proxy for that risk in a way that market-based measures do not capture. They also find that changes in ratings carry information, and that the relationship is stronger in emerging markets where the risk differences are larger.
A second contribution concerns the measurement of risk itself. The authors show that conventional measures including volatility and beta against a world index perform poorly in emerging markets, because these markets are segmented from world markets to varying degrees and because return distributions are not normal. Credit ratings and country risk measures work better as ex ante indicators of expected return.
They also examine the effect of market integration over time, since a segmented market's expected return depends on its total volatility while an integrated market's depends on its covariance with the world.
The research is from the 1990s and the emerging market universe has changed substantially, with greater integration and different risk characteristics. The general finding that credit and country risk ratings carry return information has been examined repeatedly since with mixed results.
Key takeaways 7
- Published country risk and credit ratings contain information about future equity and bond returns across countries.
- Countries with worse assessed risk subsequently delivered higher returns, consistent with compensation for bearing that risk.
- Changes in ratings carry information beyond the level of the rating itself.
- Volatility and beta against a world index perform poorly as risk measures in emerging markets because those markets are partially segmented.
- A segmented market's expected return depends on its total volatility while an integrated market's depends on its covariance with the world.
- The relationship between risk ratings and returns is stronger in emerging markets where the risk differences are larger.
- Publicly available ratings contained return information, which means the market did not fully incorporate them at the time studied.
Who should read it
Investors allocating across countries who want the evidence on whether published risk ratings carry information about expected returns.
About Campbell R. Harvey
Professor of Finance, Fuqua School of Business, Duke University; Research Associate, NBER; former editor of The Journal of Finance (2006-2012); Partner and Senior Advisor, Research Affiliates
The multiple-testing work with Liu and Zhu reset the evidentiary bar for the entire factor literature, and the Graham-Harvey CFO survey is a primary source for corporate finance practice.
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