Political Risk Measurement and Management

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Political Risk Measurement and Management

• By Bo Yu

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Political Risk and Interest Parity Theorems

• Deviations From Real Interest Parity
• Political risk can be thought of as creating
  a divergence between the physical returns
  possible from an investment and the expected
  value of returns from an investment in a country
  where there is some degree of political risk.
• A country with (disadvantageous) political
  risk has less capital and higher real interest
  rates than it would otherwise have. In
  particular, there is an interest differential
  between the risky country and a home country or
  the rest of the world r-r gt0.
• General Political Risk the expected returns of
  all investments in that country will be lower.
• Selective Political Risk the lower expected
  returns to capital pertain only to direct foreign
  investment and not to local investors.

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Deviations From Uncovered Interest Parity

• In moving from real interest rates to nominal
  interest rates, the deviations from real interest
  parity identified above result in ex ante
  deviations from uncovered interest parity.

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Deviations From Covered Interest Parity

• The deviations from real interest parity and
  uncovered interest parity attributed to political
  risk also in deviations from covered interest
  parity when the interest rates compared are for
  instruments in different political jurisdictions.
• The deviations from covered interest parity
  represent a political risk premium.

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Exchange Risk VS Political Risk

• Similarity both may explain the interest
  parities between countries.
• Differences exchange risk relates to the
  currency of denomination for claims, where as
  political risk relates to the jurisdiction in
  which an investment is made and is separate from
  the currency denomination.
• Although the interest differential for political
  risk is intuitive for financial instruments,
  political risk for multinational corporations
  should be viewed as industry-specific,
  firm-specific, or even home-country specific, and
  therefore additional analysis will be required
  for non-financial assets.

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Political Risk Assessment

• General Macro-Political Risk for
  Host-country commercial assessment firms that
  formulate indexes of political risk. But the
  index is usually a measure of the entire business
  climate, rather than just the political
  environment.
• Home-country Specific Political Factors
  these represent actions by the home country, and
  actions by the host country directed specifically
  at the home country. Here it is important to look
  at trade climates, investment attitudes, and the
  potential for an embargo or forced divestment.
• Micro Industry, Firm and Project-specific
  Political Risk Schmidt (1986) model-look at
  specific industry relative to others and gain
  some general understanding of their comparative
  political risk. Then should also analyze
  competing firms to gain a deeper understanding of
  their own firms political risk within that
  industry.
• The objective is to generate estimates of
  the probabilities of different political risks.
  There are many models available Kobrin, Blank,
  and LaPalombara (1980), or Torre and Neckar
  (1988).

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Capital Budgeting Analysis

• When political risk is introduced into the
  evaluation of an investment project, managers are
  required to adjust the capital budgeting analysis
  somehow to arrive at present value estimates that
  reflect the political risks involved. The
  preferred approach is to alter the expected cash
  flows to take account of the probabilities of
  political interventions.

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1. Analysis of Potential Expropriation Without
Compensation

• Consider Belmont Enterprises, a multinational
  coffee broker involved in all phases of coffee
  production from growing the beans to roasting
  them and distributing a ground product to
  specialty coffee shops all over the world. It is
  looking at a new investment in a bean-processing
  plant in a Latin American country with the
  following cash flows (They think that
  expropriation without any government compensation
  is the biggest concern, and they assess the
  probability of expropriation to be 25 in each of
  the next two years. And the all-equity cost of
  capital for the project is assumed to be 20)
• 
  

EPV 250,000(.75)(200,000)/(1.20)(.75)(.75)(3
00,000)/(1.20)2 -7,812.50
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Method 2

• Look at the present value of the cash flow in
  each possible outcome, and determine the
  probability associated with that outcome. The
  analysts would then take the products of each
  probability and present value of cash flow and
  sum them to get the expected present value of the
  project. Taking the product of the probability of
  the outcome and the present value of the cash
  flow if that outcome occurs, the expected present
  value is again -7,812.50

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Method 3 Break-Even Probabilities

• The break-even value for p can be determined by
  setting the expected present value to zero. If
  the probability of intervention is judged to be
  less than the break-even value, the firm then
  expects the project to be profitable
• p(-250,000) (1-p)p(-83,333) (1-p)(1-p)(125,000)
  0, solving for p0.2338 if Belmont estimates
  that the probability of expropriation exceeds
  0.2338, it should not undertake the project.

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Notes For These Models

• This model only incorporates the level of the
  probability of intervention. A more complex
  analysis would account for uncertainty in the
  estimate of the probability as well.
• This method can be extended to any type of
  political risk potential exchange controls,
  increased taxation or regulation, and so on
• This method can also be carried over to home
  actions. For example, rather than analyzing the
  probability of expropriation, we can analyze the
  probability of forced divestment.

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Analysis of Potential Nationalization With
Compensation

• Returning to the previous example, Belmont
  enterprises estimates that if nationalization
  occurs, the government will compensate the firm
  with 100,000. EPV26,041.67 but note that the
  project is profitable only if there is no
  nationalization. Other forms of compensation can
  be incorporated into the analysis, for instance,
  insurance on the subsidiary may pay for part of
  the loss. In addition, indirect compensation
  through managerial contracts. also home country
  tax laws may provide tax deduction associated
  with extraordinary losses. Finally, the parent
  may reduce its own liabilities associated with
  the project through extensive foreign borrowing.

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Tree Diagram of Potential Nationalization With
Compensation

• EPV is positive, the firm is likely to undertake
  this project.

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Managing Political Risk

• Purchasing insurance through one of the various
  political risk insurance programs.
• Alter the structure of investment to alter the
  benefits of host-country intervention.
  Centralization-versus-Decentralization As
  described earlier, a large part of the political
  risk involved with non-financial assets is
  industry-specific, firm-specific, or home-country
  specific. Multinationals must therefore analyze
  more political risk than is reflected in any
  simple interest differential. While interest
  differentials hold in the aggregate, there will
  likely be wide project-specific variation. As a
  practical matter, the countries which concern us
  the most with respect to political risk generally
  do not have developed financial markets or market
  interest rates anyway. Centralized capital
  budgeting is, therefore, usually more
  appropriate. Also may alter the investment
  timing.
• Borrow extensively in the local currency. Now a
  component of the debt denomination decision
  pertains to political risk. While outright
  default is rare, it is at least a possibility. If
  the country nationalizes the subsidiary, it also
  nationalizes debt.
• Entering into joint venture with local partners,
  especially with government-owned companies can
  reduce political risk such as Morgan Stanley in
  China.

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Managing Political Incidents

• When a host country increases regulation of
  foreign investment, at least three options exist
  ex post.
• 1. Simply following the law and altering
  operations accordingly is a first option.
• 2. Because, obeying a host-countrys
  regulations may have hidden consequences if
  following the regulation affects the way the host
  country and other governments view the company.
  The company may set precedents that other
  governments will use to regulate other
  subsidiaries. Years later, the same host country
  may even perceive that it can successfully change
  the rules again given the companys earlier
  response. Therefore, some companies may consider
  discontinuing its operations.
• 3. negotiate a settlement, or at least open
  dialogue with the government. A government
  generally will lose more than it gains if a
  company leaves the country. (Depending the
  relative bargaining power)