| Sharpening
the Tools of Country Risk Analysis
-- Roger Mills,
Marcin Peksyk and Bill Weinstein
This
paper addresses the challenge of how to express Country Risk. The authors focus
on cross-border investment and review several approaches to Country Risk Assessment
(CRA), which are placed in the context of the recent accession of many Eastern
European countries to the European Union. However the issues and the principles
would apply to the other areas of the widening global chess-board. As the creation
of a single currency zone eliminates only one kind of Country Risk, the issue
of measuring Country Risk in investment appraisals revives the debate as to whether
Country Risk should be considered as specific risk and dealt with by adjusting
the cash flows, or as a systematic risk and expressed in the additional premium
to the discount rate, which is used in determining the cost of capital. The paper
proceeds to apply and compare methods of incorporating risk factors into the cost
of capital. A Polish example is used to test methods that can be used to estimate
a country's equity risk premium. This is then followed by the issues involved
in moving from the estimation of Country Risk to project risk, adopting the perspective
of an individual company's exposure to risk. The calculations are once again speculatively
applied to Poland, and show that different expected returns arise from different
approaches. Within the great debate in the financial community as to how, where
and when to include Country Risk factors in the project appraisal process, many
s build from one point of consensus, namely, that the cost of capital (the
discount rate) should reflect only non-diversifiable risk, whereas diversifiable
risk is better handled in the cash flows. A key example using Discounted Cash
Flow (DCF) for a green field project in Poland is subjected to two parallel analyses,
one of which uses scenario analysis and the other a discount rate for Country
Risk. Not only do the results significantly diverge, one of them appears contrary
to any acceptable version of common sense. The authors therefore conclude that
there is no established single correct approach to measuring Country Risk. This
paper exhibited the need to interrogate assumptions; it did not purport to provide
answers. For the subject of Country Risk, using the EU accession countries as
fresh field for research, it is urgent that less ambiguous techniques for measuring
risk be rapidly developed. ©
2006 IUP . All Rights Reserved.
The
Dynamics of the Short-term Interest Rate in the UK
--
Antonios Antoniou,
Alejandro Bernales S and Diether W Beuermann
The
authors estimated and tested different continuous-time short rate models for the
UK. The preferred model encompasses both the `level effect' of Chan, Karolyi,
Longstaff and Sanders (1992a) and the conditional heteroskedasticity effect of
Generalized Autoregressive Conditional Heteroskedastic (GARCH) type models. The
findings suggest that, including a GARCH effect in the specification of the conditional
variance, almost halves the dependence of volatility on the rate levels. The paper
finds weak evidence of mean-reversion and volatility asymmetries in the stochastic
behavior of rates. Extensive diagnostic tests suggest that the Constant Elasticity
of Variance model of Cox (1975), with an added GARCH effect, provides a reliable
description of short rate dynamics. The authors demonstrate that the most important
feature in short rate modeling is the correct specification of the conditional
variance of changes in rates, suggesting that the conditional mean characterization
is of second order. ©
2006 IUP . All Rights Reserved.
Liquidity
Risk and Contagion
-- Rodrigo Cifuentes,
Gianluigi
Ferrucci and Hyun Song Shin
This
paper explores liquidity risk in a system of interconnected financial institutions
when such institutions are subject to regulatory solvency constraints and mark
their assets to market. When the market's demand for illiquid assets is less than
perfectly elastic, sales by distressed institutions depress the market prices
of such assets. Marking to market of the asset book can induce a further round
of endogenously generated sales of assets, depressing prices further and inducing
further sales. Contagious failures can result from small shocks. The authors investigate
the theoretical basis for contagious failures and quantify them through simulation
exercises. Liquidity requirements on institutions can be as effective as capital
requirements in forestalling contagious failures. ©
2005 The Bank of England. This article was earlier published in the Bank of England
Quarterly Bulletin, September, 2005. Reprinted with permission.
Risk Management
of Securitization Transaction: Implications
of Basel II
--Ram
Pratap Sinha
The
advent of Basel I capital adequacy proposal led to the growth of securitization
transactions by making certain assets off-balance sheet. A bank could hold less
capital on an overall basis in the Basel I regime. However, this led to an increase
in the concentration of credit risk in the books of the concerned financial institutions.
This is because commercial banks securitized their best quality loan portfolio
and as these items turn off-balance sheet, the overall portfolio riskiness increased
substantially. In order to cope with the situation, the Basel II framework dealt
with the securitization transactions in a comprehensive manner. This paper attempts
to provide a brief overview of the implications of Basel II in respect of securitization
transactions. ©
2006 IUP . All Rights Reserved. | 
