What is Sovereign Risk?
Sovereign Risk, also known as Country Risk, is the risk of default in meeting the debt obligation by a Country. It is the broadest measure of credit risk and includes country riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place.read more, political riskPolitical RiskPolitical risk is defined as a risk that emerges as a result of a change in a country's governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities.read more, and transfer risk. One of the most significant unfortunate aspects of Sovereign risk is contagious, which means that what affects one country tends to influence other countries due to the globalized, interconnected world. It is here to stay due to the inherent linkage between global economies.
Usually, BondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more issued by the government are thought of as having no default risk. However, although governments’ guarantees reduce such risk of holding government bonds, it is not eliminated, and governments do, from time to time, default.
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For eg:
Source: Sovereign Risk (wallstreetmojo.com)
Types of Sovereign Risk
Types of Sovereign Risk can take different forms as enumerated below:
- When a government has bonds that are due to mature, and they don’t have sufficient receipts to repay the maturing debts and need to re-enter the market to raise additional money via Bond Issuance in such cases, Sovereign Risk takes the form of Refinancing Risk.
- It also takes the form of a country imposing regulations, restricting the ability of debt issuers in that country to meet their obligations.
How is Sovereign Risk Measured?
There is no formula to calculate Sovereign Risk. Instead, it is measured by Sovereign Risk Rating, which measures the Default risk and is usually assigned by Global rating agencies such as Moody’s, Standard and Poor (S&P), Fitch, etc. Such Sovereign ratings assess the risk by analyzing the ability and willingness of a country to service its debt, which includes evaluation of relevant solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more and liquidity factors of the country, the political stability of the country in question as well as any limiting factors such as Financial Network and Social unrest in the country.
Example of Sovereign Risk Calculation
Let’s try to understand this concept of Sovereign risk with a hypothetical calculation example:
Raven working as a Sovereign Risk Analyst with UBS Risk Division, is trying to analyze the Risk of five Emerging Nations based on the Debt levels, Legal System Efficiency, Expenditure Management, Fiscal Discipline, Inflation level, and Central Bank Autonomy.
She has used a five-point scale ranging from 0 (Poor) to 5 (excellent) to grade the five Emerging nations on the parameters discussed above to derive the Aggregate Score and, based on the Aggregate Score, has assigned a Sovereign Rating which captures the Sovereign Risk of these Emerging Nations.
Sovereign Score based on assigned grades to each Emerging Nation in each category.
Parameter 1
Parameter 2
Parameter 3
Parameter 4
Parameter 5
Parameter 6
The Score for Sovereign Risk of these Emerging Nations is given below.
Advantages
- It enables easy comparison between different countries and allows an investor to understand and appreciate the risk and reward associated with investing in a particular country and industry. In short, it enables the cross country and across different time frame comparison.
- Ratings based on such risk act as an essential benchmark for a country to showcase its competitiveness over other countries to promote itself as an Investment destination in front of Foreign Investors.
Disadvantages
- It follows a herd mentality, which means that ratings based on Country Risk are usually impacted by converging practice. If one developing country is downgraded, others were also downgraded due to the interconnected, globalized world.
- Country Risk indirectly impacts the ability of the corporate in that country and impacts their ability to raise cheap foreign borrowing, which directly affects their profitability. A high Sovereign Risk is perceived by foreign Investors as Risky and requires a higher premium, which will increase the cost of borrowing for companies within that country.
- This usually is not exhibited in the Sovereign ratings until its too late (the country might have defaulted). This is due to the inherent vested interest of the government of various countries to ensure their ratings are higher and the Rating Agency’s incentive to accommodate the states (which are its clients).
- It is primarily based on Historical data points and analyzing the same to inference future events and, as such, lacks a lot of objectivity.
Conclusion
Sovereign Risk is an important yardstick that is closely followed and taken into consideration while making an investment in any country by foreign Investors and is typically done by evaluation of Country Risk Rating.
Country Risk increases with deteriorating fiscal conditions, political uncertainty, social unrest, deflation, the legal system, deep recession, etc. Foreign Investors, while investing in any sovereign, should make a thorough analysis of this risk to ensure they are duly compensated for the risk undertaken.
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This has been a guide to what is a sovereign risk and its definition. Here we discuss how to calculate and measure Sovereign Risk along with examples, advantages, and disadvantages. You can learn more about Financing from the following articles –
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