Quiz 14: Political and Country Risk
The difference between the dollar interest rate of 7.10% rate and the U.S. LIBOR of 3.25% indicates that the banks of Argentina may not be able to pay back loan and hence, it reflects country risk. It does not reflect currency risk because both deposits are in dollars. The difference between Peso 90-day rate of 8.99% and 90-day dollar deposits of 7.10% banks of Argentina reflects currency risk. The credit risk is equal on both available options as the deposits are offered by the same banks.
Every country has different legal, political, economical and social environment. So, there is always distinctive risk associated with in terms of these factors. It includes the risk that property will be expropriated without compensation, change in tax rules and regulations, strikes. Political risk: It is the risk which can arise due the actions taken by a government that can adversely affect cash flows of a company. The most extreme action can be when governments seize property without providing compensation to the owners in a total expropriation Country risk: It is much broader concept which can result in negative effects of a country's political, economical and financial environment. Like if there is a recession in a country, it will reduce its aggregate demand as well as the revenues of exporters to that nation. Labor strikes, differences between rival ethnic or religious groups are considered as country risks. Sovereign risk: When a government defaults on loan or bonds held by foreigners is called sovereign risk. These defaults is not like a case where company defaults due to bankruptcy as it is difficult to take a particular country to the court because there are no formal bankruptcy proceedings for the governments. There are some provisions that can restrain governments from defaulting on loans or bonds held by foreigners are as follows: • That country's assets may be seized if located in the jurisdiction of a creditor. There was a time in early 1986, when the Peruvian government got back around $700 million worth of gold and silver that it had been holding abroad. • It will be difficult for the country to borrow in future, if it still get some funds then the cost of borrowing funds will be high and expensive which can result in bad economic consequences. • There will be difficulty in engaging in international trade. • Default loan or bonds held by foreigners can result in economic crises.
By equating the return of the U.S. LIBOR rate i.e. i LIBOR with the return for dollar deposits in Argentina i.e. i ARG , and p as default probability: The dollar interest rate i.e. i ARG is 7.10% and the U.S. LIBOR rate i.e. i LIBOR is 3.25%. Substituting: Thus, the probability of default is 0.95%. As per the Uncovered Interest Rate Parity, Both the deposits i.e. Peso and Dollar will provide same expected return. Consequently, hence, … (1) Where S (t+1) is the spot exchange rate at time t+1 in dollars per peso. Hence we consider it an expected exchange rate. Now, Let q be the probability of devaluation. Where S (t) =1. Now Substituting in Equation 1, the value of q will be: Hence, the probability of 25% devaluation is 1.85%.