Video summary

Country Risk: Determinants, Measures and Implications - The 2026 Edition

Main summary

Key takeaways

Finance

Core message

  • Country risk varies materially across countries and cannot be diversified away in modern global markets (correlations rise, especially during crises).
  • Therefore, country risk should be incorporated into discount rates/hurdle rates and company valuations rather than relying on country of incorporation or assuming that “global diversification fixes it.”

When/How the updates are made (coverage and timing)

  • Data/topic updates are performed annually:
    • March (since 2009): paper update on equity risk premiums
    • July (every year): update on country risk
  • Regular datasets are updated on the first five days of every year.
  • The “2026 edition” refers to the latest country risk update available, with timing references including:
    • start of July 2026
    • mid-2025

Why country risk matters (and why earlier assumptions fail)

Assumption 1: “If you analyze US companies, you avoid country risk”

  • Rebuttal: even “developed-market” companies can have large revenue exposure to risky markets.
  • Examples mentioned: Coca-Cola, Nestlé.

Assumption 2: “Country risk can be diversified away”

  • Rebuttal: correlations across countries increased with globalization; during crises markets move together.
  • Conclusion: country risk is not diversifiable.

Main determinants of country risk (4 factors)

The speaker attributes differences in country risk to four core country-level drivers:

  1. Political structure

    • Whether regimes are democratic vs authoritarian
    • Trend cited:
      • Only ~7% of the global population (end of 2025) lived in purely democratic parts of the world; ~93% lived under some authoritarian variation.
    • Business trade-off:
      • Democracies: risk tends to be continuous (policy/regulation changes as governments change).
      • Authoritarian regimes: risk is more discrete, but when it hits it is more likely catastrophic.

  2. Corruption

    • Measured via Transparency International corruption scoring.
    • Treated as an implicit tax on operating costs (including possible inability to deduct “corruption costs”).
    • The speaker argues corruption is driven more by:
      • how well bureaucrats are paid
      • perceived rule-following by leadership

  3. Exposure to violence

    • Measured via a “Vision of Humanity” peace/violence index.
    • Business impact:
      • increased insurance/security spending
      • reduced margins/profitability

  4. Legal systems (property rights + contract enforcement)

    • Emphasis on timeliness of enforcement.
    • Example: a court taking ~35 years to rule is almost as damaging as an arbitrary/capricious court.

Climate risk (explicit treatment)

  • Climate change is not front and center in the country risk framework because:
    • exposure appears broad across countries (index suggests most places are exposed)
    • it hasn’t yet shown up in company profitability in a tangible enough way to materially change country risk
  • The speaker plans to track annually and incorporate it later if it becomes financially material.

How country risk gets “priced” (sovereign default risk)

  • Country risk shows up most directly in sovereign bond/debt markets, because lenders focus on default risk.

Sovereign default dynamics

  • Default frequency:
    • defaults soared in the 1980s/1990s
    • declined in the 2000s onward but remains substantial
  • Default type:
    • the share of defaults on sovereign bonds is higher now than on loans (loans are more bank-like)

Local-currency debt is not “default-free”

  • Even in government own currency, defaults can occur due to:
    • choosing between printing money → inflation soars
    • or defaulting to avoid hyperinflation
  • Therefore, local-currency nominal rates do not eliminate sovereign default risk.

Geographic pattern (example timing: end of 2023)

  • Historically, Latin America has been described as the epicenter of sovereign default.
  • By end of 2023, defaults appear across:
    • Asia
    • parts of Europe, including eastern Europe and Russia

Measures of sovereign default risk (and related instruments)

1) Sovereign credit ratings (S&P / Moody’s / Fitch)

  • Pros: widely accessible.
  • Concern: potential delay (not necessarily large systematic bias).
  • Coverage limitations:
    • “Frontier markets” sometimes have no ratings (examples: Syria, Afghanistan, North Korea).
    • Russia sovereign rating was withdrawn.

2) Market-based sovereign CDS spreads (default insurance)

  • Uses sovereign CDS as a market-implied default spread.
  • CDS availability:
    • only about ~80 countries
    • “about half the world” lacks sovereign CDS spreads
  • Intended role: a second cross-check against ratings.
  • CDS-based sovereign spreads are reported as of start of July 2026.

Disclosure/caution implied: ratings are often distrusted, but the speaker argues they’re “pretty good in aggregate,” with delay being the bigger issue.

Composite country risk scores (PRS vs. Economist) — why hard to use directly

  • Referenced composite risk services:
    • PRS (Political Risk Services)
    • The Economist country risk service
  • Major problem: idiosyncratic construction and directionality
    • Economist: low = safe, high = risky
    • PRS: opposite direction
  • Different factor weightings can yield contradictory outputs for the same country.

Example: with PRS, the US is described as “riskier than it used to be,” potentially even riskier than Ghana—illustrating that “numbers you can pick and choose.”

Step-by-step framework: building equity risk premiums by country

A) Start with a “mature market” equity risk premium (S&P 500 implied return)

  • The speaker estimates an implied equity risk premium for the S&P 500 using a cash-flow/discounting approach:
    • S&P 500 level at close of trading on June 30, 2026: ~7500
    • Cash flows: dividends + buybacks
    • Forecast horizon: next five years
    • Terminal growth (year 6): grows at the economy’s nominal growth rate, proxied by the T-bond rate
    • Solve discount rate so PV(expected cash flows) = index level
  • Result:
    • implied investor-required return / discount rate: IRR ~ 8.65%

B) Convert to an equity risk premium (adjusting “risk-free” for US default risk)

  • Use US Treasury nominal rate proxy, but adjust because:
    • Moody’s downgraded the US from AAA to Double-A1 in mid-2025
  • Default spread cited:
    • for Double-A1: “~2%” (contextually)
  • Resulting “risk-free” rate (US dollars, adjusted):
    • 4.23%
  • Implied equity risk premium:
    • ~4.2% using unadjusted T-bond
    • ~4.42% using risk-adjusted risk-free rate
  • Decision rule:
    • Mature market premium = 4.2%
    • US equity risk premium = 4.42%

C) Add country-specific risk premium using sovereign default spreads

  • For rated countries:
    • If country is AAA rated:
      • equity risk premium assigned: 4.2%
    • If not AAA:
      • use sovereign default spread by rating
      • adjust for equity vs bond volatility/risk:
        • equity risk is higher than bond risk
        • estimate ratio from 5 years of data:
          • stdev(emerging equities) / stdev(emerging sovereign bonds) = 1.55
      • Convert default spread to equity add-on:
        • Country equity add-on = default spread × 1.55
  • Total country equity risk premium:
    • 4.2% + (default spread × 1.55)

Example (explicit):

  • If default spread = 2%:
    • equity add-on = 2% × 1.55 = 3.1%
    • equity risk premium = 4.2% + 3.1%

D) For unrated countries: extrapolate using PRS scores

  • For ~20 countries with no ratings:
    • use PRS
    • find similarly scored rated countries
    • extrapolate an equity risk range (explicitly acknowledged as stretching)

E) Timeline/correction disclaimer

  • Two weeks earlier, an earlier version had different numbers.
  • Reason: not fully corrected default spreads at that time.
  • Presented as “final numbers” until next update:
    • next update: January 2027

Key output numbers (as stated)

  • S&P 500 implied discount/required return: ~8.65%
  • US equity risk premium: 4.42%
  • Mature market premium: 4.2%
  • AAA countries’ assigned equity risk premium: 4.2%
  • Equity-vs-bond scaling factor:
    • 1.55
  • US adjusted risk-free component:
    • adjusted “risk-free” rate: 4.23% (after accounting for default spread)

How country risk affects company valuation (recommendation/caution)

1) Use a country “life cycle” narrative (how much emphasis matters)

  • Framework: countries progress through growth → maturity → decline
  • Valuation narrative implication:
    • riskier/declining countries should dominate the company story
    • mature countries fade into the background
  • Examples:
    • Venezuela: country story dominates.
    • Even large emerging markets like Brazil/India: embed country story.
    • Germany example:
      • German company valuations often need less emphasis on a “Germany” narrative.

2) Don’t default to country of incorporation for equity risk

  • Speaker calls this practice “amazing” and “shocked” by how common it is.
  • Reason: risk exposure comes from revenues/operations.
  • Examples used:
    • Coca-Cola: may have ~60% revenues outside US
    • Infosys: may have ~90% revenues outside India
  • Evidence cited across indices/fund/investment universes:
    • FTSE, Nikkei, S&P index/funds, Sensex (revenue often comes from outside the domestic market)

3) Weight risk by where operations come from (depends on business type)

  • Suggested mapping:
    • Consumer products: weight by revenues
    • Natural resources: weight by production/source location
    • Manufacturing/mixed: use a mix of revenues and production

4) Hurdle rates must vary by country and business unit

  • Example structure:
    • Project in India:
      • risk-free rate tied to currency
      • beta tied to business type
      • equity risk premium tied to India equity risk
    • Project in Hungary:
      • use Hungarian equity risk premium
      • plus the appropriate asset/business beta (example referenced: “G aircraft project in Hungary”)
  • Result: multinationals require more complex hurdle-rate construction, but it’s more realistic.

Currency: a measurement device, not the driver

  • Currency is treated as reflecting underlying country risk, not causing it.
  • Risk-free rates are currency-specific; the speaker builds them by:
    • taking local-currency government bond yields
    • subtracting the default spread
  • Explicit numeric example (Turkey):
    • Turkish lira “risk-free” cited around ~20%, leading to hurdle rates around 28–30%
    • If valued in euros, risk-free starts around ~3% (German euro bond rate)
    • With consistent currency treatment, NPV/value should be invariant to currency choice.
  • Currency consistency principle:
    • discount rate currency must match cash flow currency
    • high-inflation currencies raise both:
      • discount rates
      • cash flow growth rates
    • therefore, NPV/value stays consistent under consistent assumptions.
  • Currency pegs:
    • can be trusted only if expected inflation is similar between peg currency and base currency.

Disclosures / cautions mentioned

  • The speaker states the work is a work in progress and that he may “get things wrong” and invite correction.
  • No explicit “not financial advice” line appears in the provided subtitles.

Instruments / entities mentioned

Financial benchmarks and market inputs

  • S&P 500
  • T-bond / US Treasury bond rate proxy
  • Sovereign CDS (credit default swaps for sovereigns)

Ratings agencies

  • S&P
  • Moody’s
  • Fitch

Examples (countries/markets/indices)

  • Countries referenced: Nigeria, Germany, Afghanistan, Russia, Latin America, Egypt (mention of Egyptian pounds), Turkey, Kenya (Kenyan shilling), Switzerland, US, Brazil, India (and others as context)
  • Indices/families referenced: FTSE, Nikkei, Sensex
  • Companies referenced: Coca-Cola, Nestlé, Zomato, Infosys (no tickers provided)

Presenters / sources referenced

  • Presenter/author: the primary speaker (unnamed in the subtitles), who publishes annual equity risk premium and country risk updates.
  • Referenced external sources/indices:
    • The Economist (democracy/autocracy measures; also political risk composite service)
    • Transparency International (corruption)
    • Vision of Humanity (peace/violence)
    • Property Rights Alliance (property rights protection)
    • PRS (Political Risk Services)
    • S&P / Moody’s / Fitch (sovereign ratings)
    • Sovereign CDS market pricing (market-based default spread input)
    • Indices: S&P 500, FTSE, Nikkei, Sensex

Original video