A country risk premium reflects the higher risk associated with investing in a specific nation. It is an increase in available interest rates above the standard, used to entice investors who might not find the nation’s financial products appealing because of the higher chance of default. International agencies calculate the risk of investing in various nations for the benefit of investors and other interested parties. These calculations can be used to determine a country risk premium for the purpose of developing investment products.
To determine any risk premium, it is necessary to have reasonable financial instruments for comparison to fairly and accurately assess them. For example, a bond with a five year yield may behave differently than a bond with a one year yield, which would make them poor candidates for comparison. Calculations to find a country risk premium look at the overall risk of default compared to a baseline, determining how much more a nation would need to offer in interest to appeal to investors.
For example, Switzerland is generally a country with a low risk of default; investors who buy Swiss bonds can be assured of repayment in full. In contrast, Italy offers a much riskier investment. If both nations offer five year bonds denominated in Euros with the same interest rate, investors would prefer the Swiss bonds, because they are more likely to be repaid. Italy might need to offer a country risk premium, a higher interest rate to attract investors. If the Swiss offer 4%, for instance, the Italians might offer 6%.
The amount of a country risk premium can fluctuate over time. Considerations may include political circumstances, economic conditions, and external factors like severe weather. A nation in political upheaval would need to offer a much higher country risk premium to appeal to investors, who would have legitimate concerns about repayment, especially with long term financial instruments. Nations with poor economies might also need to offer more to allay concerns that the government might not be able to repay debts when they mature.
Investors considering their options can weigh the country risk premium in their calculations. The benefit is that they may earn more in interest on their investments, generating bigger earnings. They could also lose the principal if the debt instrument is not repaid. Risk-averse investors may view the country risk premium as not worth the potential danger, while others might be drawn to such investment on the grounds that it could offer more money.