Country
and Currency Risk Premia in an Emerging Market
By Ian Domowitz, Jack Glen,
and Ananth Madhavan
Abstract
The magnitude and determinants of country and currency risk premia
are of considerable importance to investors and policymakers. Unique
data on peso and dollar denominated debt issued by the Mexican government
is used to identify and analyze the intertemporal prices of country
and currency risk, without resorting to assumptions concerning investor
preferences. The results suggest that government authorities in
emerging markets can significantly reduce the cost of raising capital,
if they can improve international perceptions of the risk of possible
currency devaluations and sovereign default. Currency risk is the
most important factor, a point especially noteworthy given recent
financial crises in Thailand and Malaysia. The premium demanded
by investors with respect to currency and country factors shows
persistent increases in response to volatility shocks in financial
markets. From a policy viewpoint, these findings also suggest that
efforts to promote greater stability in domestic security markets
can substantially lower government borrowing costs over a long horizon.
Our results shed light on the process by which investors' expectations
of risk are formed. Rational expectations theories of pricing, as
applied to risk premia, are supported for currency risk, while country
risk factors appear to be correctly priced only when attention is
strongly focused on political events, due to policy shocks, elections,
and political assassinations, for example. Policy debates continue
over whether or not the 1994 devaluation was anticipted and why
the consequences were so severe at market and government levels.
Our analysis of the structure of interest rates, country and currency
risk premia, expectational errors with respect to the pricing of
such premia, and the behavior of country fund discounts all lead
us to the conclusion that the develuation was unanticipated. This
observation is consistent with capital flows out of the country
post-develuation, rather than the usual observations that such flows
occur prior to a major government devaluation event.
Ian Domowitz, Department of Economics, Northwestern
University Jack Glen, Economics Division, International Finance Corporation Ananth Madhavan, Department of Finance, University of Southern
California
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