Political Risk Measurement and

Management

By Bo Yu

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 >0.

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.

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.

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.

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.

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 firm’s 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).

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.

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%)

Year US $ Cash Flows

0 -250,000

1 200,000

2 300,000

Year Expected US $ Cash Flows

0-250,000 ( a known cash

outflow)

1 (.75) 200,000

2 (.75) (.75) 300,000

EPV= $250,000+(.75)($200,000)/(1.20)+(.75)(.75)($300,000)/(1.20)2 = -$7,812.50

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

Year Probability PV of Cash Flows

Expropriation in Year 1 0.2500 -250,000

Expropriation in Year 2 0.1875 -250,000 + 200,000/1.20= -83,333

No Expropriation 0.5625 -83,333 + 300,000/(1.20)2 =125,000

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 p=0.2338; if Belmont estimates that the probability of expropriation exceeds 0.2338, it should not undertake the project.

Year Probability PV of Cash Flows

Expropriation in Year 1 P -250,000

Expropriation in Year 2 (1-p)p -83,333

No Expropriation (1-p)(1-p) 125,000

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.

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. EPV=$26,041.67: 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.

Year Probability PV of Cash Flows

Expropriation in Year 1 0.25 -250,000+100,000/1.20=-166,666.67

Expropriation in Year 2 0.1875-250,000 + 200,000/1.20+ 100,000/(1.20)2= -

13,888.89

No Expropriation 0.5625 -250,000 + 200,000/1.20+300,000/(1.20)2 =125,000

Tree Diagram of Potential Nationalization With Compensation

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

-250 ， 000

Ongoing p=0.75

Nationalization p=.25

+200,000

+100,000

Year 1 Year 2

+300,000

+100,000

Ongoing p=0.75

Nationalization p=0.25

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.

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-country’s 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 company’s 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)