The country risk premium refers to the difference between the higher interest rates that less stable and riskier countries must pay to attract investors, and the interest rates of an investor’s home country.

By investing in less stable and poorly-rated countries you can expect a higher return, but you also have to accept a higher level of risk. For example El Salvador is a much more probable candidate for insolvency than Germany.

Investing in Bolivia is considered riskier than investing in the USA. Have you ever wondered how this riskiness can be calculated? The answer is particularly important to investors in junior mining stocks who could be particularly affected by geographical (and legal) risk. For instance, if a certain company’s mines are suddenly nationalized then the stock price will plummet.

Country risk in the above example is based on different economic concepts and policies introduced throughout the years as well as some external factors. The situation is so complex that the difference seems to be unexplainable at first sight. However, thanks to the country risk premium, we are able to measure, define and compare such differences with a decent accuracy. As a result, we are better able to estimate risk associated with investing in junior stocks with operations in various countries.

The country risk premium is the difference between the imposed market interest rates for the government of a given country (often called the benchmark country ) and comparable rates for other countries. Usually this term refers to a positive divergence between these rates.

The benchmark country is a country with a stable, well-respected and developed business environment. These countries are often referred to as “low risk” or “developed.” Thanks to these conditions, the cost of capital and consequently, the expected returns on low-risk investment projects, remain at a stable but relatively unimpressive level. This term is commonly used in reference to government bonds. The USA is an example of a benchmark country. In other countries with a less attractive business environment investors may be more reluctant to make loans or invest in the market. That is why the government has to offer relatively higher interest rates compared to those of the benchmark country. Investors are more willing to accept the risk if the risk premium is higher.

To sum up, the country risk premium may be defined as an investor’s premium for accepting a higher level of overall risk in the business environment. The relative risk levels in various countries may be easily compared using bond- or sovereign ratings issued by the rating agencies (Moody’s, S&P, Fitch). The lower the rating, the higher the risk. Investors have to be aware of the fact that the relationship between country risk and country risk premium may be flawed. The optimum level of acceptable risk has to be estimated according to other economic factors and principles.

A wise investor will always think about the possible costs and profits of each investment, especially when considering investing in riskier countries. In some cases it may pay off, while in others it can be a total flop. Proper diversification is an important caveat. By smart diversification one can minimize the sum of risks or even make the particular countries’ risks cancel each other out. To do this you need proper tools and data. We demonstrate how this can be done below.

The common way of measuring the country risk premium is by taking the difference between the country’s average bond yield and the default-free government’s bond yield (a bond whose issuer is highly unlikely to default – for example US T-bonds). Please look at the table below, based on the work of Professor Aswath Damodaran of the Stern School of Business at NYU (original version available here). The table shows the level of country risk premium by country (as of 2011), as well as the long term rating issued by the rating agencies. US T-bonds were used as default-free bonds: