What it is:
How it works (Example):
Let's assume that you are considering purchasing either a bond issued by the government of Canada or a bond issued by the government of Nigeria. Both governments intend to use the funds for similar projects. Which bond is more likely to default? That depends in part on your assessment of country risk .
Political and economic instability are two of the biggest reasons countries default on their bonds, so the question of determining country risk is at least partially a matter of comparing these factors for Canada and Nigeria. Analysts scrutinize tax systems, the influence of certain political parties, evidence of corruption, inflation rates, education systems, demographics, and a wide variety of other factors to determine and predict sources of instability.
Why it Matters:
Country risk is a concern because political and economic unrest create volatility. In turn, investors demand higher returns as compensation for this added risk. As you can imagine, Canada would have much less country risk than Nigeria, but in exchange for this peace of mind, Canadian bonds will yield less than the Nigerian bonds. As a result, the presence and degree of country risk makes it more expensive for many emerging economies or struggling countries to borrow money.