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Political Risk

When multinational companies invest abroad, their financial managers need to consider the political risks that are involved. By this, we mean the threat that governments will change the rules of the game after an investment is made. At worst, the government may expropriate the company`s assets without compensation. Or it may simply insist that the company keep in the country any profits that it makes.

Businesses in every country are exposed to the risk of unanticipated actions by governments or the courts. But in some parts of the world foreign companies are particularly vulnerable. Several organizations publish regular rankings of countries in terms of their political risk. For example, the PRS Group places countries on a scale of 1 to 100 based on factors such as regime stability, financial transfer, and turmoil. The following table presents the 10 least and most risky countries based on these factors.

AVOIDING FUDGE FACTORS

We certainly don`t pretend that we can put a precise figure on the cost of capital for foreign investment. But you can see that we disagree with the frequent practice of automatically increasing the domestic cost of capital when foreign investment is considered. We suspect that managers mark up the required return for foreign investment because it is more costly to manage an operation in a foreign country and to cover the risk of expropriation, foreign exchange restrictions, or unfavorable tax changes. The nearby box discusses the sources of political risk. A fudge factor is added to the discount factor to cover these costs.

We think managers should leave the discount rate alone and reduce expected cash flows instead. For example, suppose that KW is expected to earn L2.5 million in the first year if no penalties are placed on the operations of foreign firms. Suppose also that there is a 20 percent chance that KW`s cash flow may be expropriated without compensation.

The expected cash flow is not L2.5 million but .8 ГЧ 2.5 million = L2.0 million. The end result may be the same if you pretend that the expected cash flow is L2.5 million but add a fudge factor to the discount rate. Nevertheless, adjusting cash flows brings management`s assumptions about ¬political risks ­ out in the open for scrutiny and sensitivity analysis.

Summary

What is the difference between spot and forward exchange rates?

The exchange rate is the amount of one currency needed to purchase one unit of another currency. The spot rate of exchange is the exchange rate for an immediate transaction. The forward rate is the exchange rate for a forward transaction, that is, a transaction at a specified future date.

What are the basic relationships between spot exchange rates, forward exchange rates, interest rates, and inflation rates?

To produce order out of chaos, the international financial manager needs some model of the relationships between exchange rates, interest rates, and inflation rates. Four very simple theories prove useful:

In its strict form, purchasing power parity states that $1 must have the same purchasing power in every country. You only need to take a vacation abroad to know that this doesn`t square well with the facts. Nevertheless, on average, changes in exchange rates match

differences in inflation rates and, if you need a long-term forecast of the exchange rate, it is difficult to do much better than to assume that the exchange rate will offset the effect of any differences in the inflation rates.

In an open world capital market real rates of interest would have to be the same. Thus differences in nominal interest rates result from differences in expected inflation rates.

This international Fisher effect suggests that firms should not simply borrow where interest rates are lowest. Those countries are also likely to have the lowest inflation rates and the strongest currencies.

Interest rate parity theory states that the interest differential between two countries must be equal to the difference between the forward and spot exchange rates. In the international markets, arbitrage ensures that parity almost always holds.

The expectations theory of exchange rates tells us that the forward rate equals the expected spot rate (though it is very far from being a perfect forecaster of the spot rate).

What are some simple strategies to protect the firm against exchange rate risk?

Our simple theories about forward rates have two practical implications for the problem of hedging overseas operations. First, the expectations theory suggests that hedging exchange risk is on average costless. Second, there are two ways to hedge against exchange risk ¤one is to buy or sell currency forward, the other is to lend or borrow abroad. Interest rate parity tells us that the cost of the two methods should be the same.

How do we perform an NPV analysis for projects with cash flows in foreign currencies?

Overseas investment decisions are no different in principle from domestic decisions. You need to forecast the project`s cash flows and then discount them at the opportunity cost of capital. But it is important to remember that if the opportunity cost of capital is stated in dollars, the cash flows must also be converted to dollars. This requires a forecast of foreign exchange rates. We suggest that you rely on the simple parity relationships and use the interest rate differential to produce these forecasts. In international capital budgeting the return that shareholders require from foreign investments must be estimated. Adding a premium for the ¬extra risks ­ of overseas investment is not a good solution.