Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-1 Chapter 9 Country Risk 9.1Country Risk Assessment 9.2Strategies for Managing Country Risk 9.3Country Risks and the Cost of Capital 9.4Summary

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-2 The risks of international business F Political risk »is the risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate. F Financial risk »refers more generally to unexpected events in a country’s financial, economic, or business life.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-3 Sources of country risk F Macro risks »affect all firms in a host country F Micro risks »specific to an industry, firm or project

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-4 Political risk F Examples of political risks »Expropriation risk »Disruptions in operations »Protectionism »Loss of intellectual property rights

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-5 Financial risk F Examples of financial risks »currency (foreign exchange) risk »interest rate risk »inflation »current account balance

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-6 Strategies for managing country risk F Negotiate the investment environment with the host country prior to investment »The investment environment »The financial environment F Obtain political risk insurance F Structure foreign operations to minimize country risk while maximizing expected return

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-7 Political risk insurance F Ideally, insurable risks possess the following properties »The loss is identifiable in time, place, cause, and amount. »A large number of individuals or businesses are exposed to the risk, ideally in an independently and identically distributed manner. »The expected loss over the life of the contract is estimable, so that reasonable premiums can be set by the insurer. »The loss is outside the influence of the insured.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-8 Political risk insurance F Insurable political risks include »Expropriation due to –war –revolution –insurrection –civil disturbance –terrorism »Repatriation restrictions »Currency inconvertibility

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-9 Political risk insurance F Political risk insurers »International –World Bank’s Multilateral Investment Guarantee Agency »Government export credit agencies –United States - Overseas Private Investment Corporation –United Kingdom - Export Credits Guarantee Department »Private –Lloyd’s of London –American International Group F MNCs are “self-insuring” if their risks are spread out over a large number of countries

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-10 Political risk and the structure of foreign operations F Structure foreign operations to minimize country risk while maximizing expected return »Limit the scope of technology transfer to foreign affiliates to include only non-essential parts of the production process »Limit dependence on any single partner »Enlist local partners »Use more stringent investment criteria F Plan for disaster recovery

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-11 Country risks and the MNC’s cost of capital F From shareholders’ perspective, only nondiversifiable country risks should affect the cost of capital »Whether a particular country risk is diversifiable depends on whether investors are locally or globally diversified F From managers’ perspective, country risks are often not diversifiable »This creates an agency conflict as managers represent shareholders

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 9-12 The evidence on country risks and required returns F Erb, Harvey, and Viskanta found that country risk measures - particularly financial risk measures - are correlated with future equity returns and risks * »A decrease (increase) in country risk tends to be followed by a rise (fall) in equity returns in that country. »Countries with high country risk tend to have more volatile returns than countries with low country risk. »Countries with high country risk tend to have lower betas (systematic risks) than countries with low country risk. * Claude Erb, Campbell Harvey, and Tadas Viskanta, “Political Risk, Financial Risk and Economic Risk,” Financial Analysts Journal 52, November/December, 1996.