Country Risk in Global Financial Management

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Financial Markets and Investment Strategies Global Financial Crisis and Policies Financial Risk and Volatility Modeling

Abstract

Countv Risk ilz Global Financial ManagementMost investors, I suspect, have not thought a great deal about how to define and measure country risk.Fortunately for those of us who have not, Claude Erb, Campbell Harvey, and Tadas Viskanta certainly have.In this monograph, they summarize and extend what they have learned and written about the topic during the better part of the past 10 years.In particular, they make a strong case for country risk as the preeminent influence on investment performance, dominating even currency risk, on a worldwide basis.Interestingly, however, they also note that economic theory is largely silent on how to incorporate country risk in asset-pricing models, which means that it may well be an omitted factor in most formal explanations of that type.Erb, Harvey, and Viskanta also discuss the way country risk is usually defined and ask the fundamental question: Does greater risk, to the extent that it is systematic in nature, lead to greater expected return for the investor?Using several different specifications of the risk-return relationship (including Barro's [1996a] macroeconomic growth model), they conclude that theory does appear to be useful; the most common country risk measures are significantly correlated with that country's economic growth rate and its expected security returns.The authors also examine several commonly used measures of country risk and demonstrate how these statistics can be used in the estimation of expected returns, volatilities, and correlations in more than 100 countries.They conclude with several practical suggestions for how money managers can use this analysis to advantage as they incorporate foreign investments into their asset mix.Although not long, this monograph is densely packed with timely, and sometimes surprising, information about country risk in global financial management-a subject that is certain to become more important with each passing year.Indeed, the data and interpretations contained in this monograph would justify a publication of many more pages than what you now hold in your hands.I think that you will find the succinctness of their arguments and exposition to be refreshing, if not always simple.They have produced an excellent synopsis of a topic that is poorly understood in both the academic and practitioner communities, and the Research Foundation is proud to have helped in that effort.

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References

1986Increasing Returns and Long-Run Growth 1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*1992The Cross-Section of Expected Stock Returns 1973Risk, Return, and Equilibrium: Empirical Tests 1996Financial Dependence and Growth 1965The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets 1976The arbitrage theory of capital asset pricing 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]

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