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Country and Currency Risk Premia in an Emerging Market

  • Ian Domowitz
  • Jack Glen
  • Ananth Madhavan

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.

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Paper provided by Institute for Policy Resarch at Northwestern University in its series IPR working papers with number 97-26.

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Handle: RePEc:wop:nwuipr:97-26
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