Measure currency and country risk premia for Indian markets

Abstract

Abstract As the home –country biases for investing are reducing and global portfolio investment is on rise the understanding and determination of country and currency risk has become increasingly significant. In this study we have attempted to measure currency and country risk for an emerging economy like India in the context of global investor investing in India. The concept of country risk unlike currency risk is not widely understood. There is abundant literature on country risk however there is no universally agreed definition for country risk. The literature differs on the terminology used for these types of risk (country/ political/ cross-border risk), sources of risk and the type of investment which face these risks. Broadly we can define country risk as “ All business transactions involve some degree of risk when business transitions occur across international borders they carry additional risks not present in domestic transactions. These additional risks are called country risks.” An estimation of country risks can be obtained by comparing financial parameters of an emerging market like India and a mature market likes can US. Yield on dollar denominated government bonds(for India and US) and the standard deviations observed in equities in US and India are some of the financial parameters which help us estimate county risk for India. Currency risk can be measured in simple but crude from as the variation in the exchange rates. A more generalized approach that has been used is to treat exchange risk as one of the factors in the multi- factor theory . An Important IT stock (infosys) is selected to measure the exchange risk premium as this stock is most likely to be affected by exchange rate fluctuation (Infosys has nearly>50% of its business from US.) There is little evidence to suggest that exchange risk is very strongly priced in Indian equity market. However country risk premium in the debt markets is very observable from the models used in the report. We find no evidence of either unconditional or conditional risk premium for exposure to Exchange rate risk in the debt market. Our weak results for pricing these risks in the Indian market are not without ramifications for the Indian finance community. International portfolio managers with access to both Indian capital markets and global markets may want to invest in a country these risks are priced significantly and maximize their wealth.