Modelling Ratings Effects in Country Risk

Country risk has recently become a topic of major concern for the international financial community. A critical assessment of country risk is essential because it reflects the ability and willingness of a country to service its financial obligations. Various risk rating agencies employ different methods to determine country risk ratings, combining a range of qualitative and quantitative information regarding alternative measures of economic, financial and political risk into associated composite risk ratings. This paper provides an international comparison of country risk ratings compiled by the International Country Risk Guide (ICRG), which is the only international rating agency to provide detailed and consistent monthly data over an extended period for a large number of countries. As risk ratings can be treated as indexes, their rate of change, or returns, merits attention in the same manner as financial returns. For this reason, a constant correlation multivariate asymmetric ARMA-GARCH model is estimated and tested. The empirical results provide a comparative assessment of the conditional means and volatilities associated with international country risk returns across countries and over time, highlight the importance of economic, financial and political risk ratings as components of a composite risk rating, evaluate the multivariate effects of alternative risk returns, and evaluate the usefulness of the ICRG risk ratings in modelling risk returns.