1. Country Risk Management in Global Financial Markets
Alina 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
1
http://www.investopedia.com/terms/d/diversification.asp#axzz1h1Dl6Wke accessed on 20 Dec 2011
2
“Fundamentals of Corporate Finance”, Brearley, Myers, Marcus, 6th Ed. Chapter 11, page 328

2. Country Risk Management in Global Financial Markets
Alina Sachapow, Gloria Armesto & Navi Phifer
20 Dec 2011
investments are negatively correlated. This is why it makes sense to invest in different countries to
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
3
“Fundamentals of Corporate Finance”, Brearley, Myers, Marcus, 6th Ed. Chapter 11, page 324
4
„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.

3. Country Risk Management in Global Financial Markets
Alina Sachapow, Gloria Armesto & Navi Phifer
20 Dec 2011
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
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.
6
Ibid, Ch. 10 pg 244.
7
Ibid, Ch. 13 pg 325.
8
Ibid, Ch. 14 pg 378