Transcript Management of Credit Risk and Political Risk

International Investment Decision
under Political Risk and Credit Risk
By
Dr. Hsuan-Chu Lin
Department of Accountancy and Graduate Institute of
Finance
National Cheng Kung University
APEC Symposium on Enhancing SME Capacity of
Managing the Risks Associated with Trade Liberalization
8/17/2011
What are Political Risk and Credit
Risk?
 Macro-level: non-project specific risks
 Political Risk: The risk of loss when investing in a given
country caused by changes in a country's political structure
or policies, such as tax laws, tariffs, expropriation of assets,
or restriction in repatriation of profits.
 Weston and Sorge's (1972) definition is representative:
"Political risks arise from the actions of national
governments which interfere with or prevent business
transactions, or change the terms of agreements, or cause
the confiscation of wholly or partially foreign owned
business property"
What are Political Risk and Credit
Risk?
 Micro-level: project specific risks
 Credit Risk: The risk due to uncertainty in a counterparty's
(also called an obligor's or credit's) ability to meet its
obligations.
 Generally speaking, from an international trading
perspective, political risk should be relatively emphasized
than credit risk.
Why do we care?
 The two risks bring uncertainty to the expected payoffs of
investing an international project and further affect a firm’s
decision on whether to take the project.
 They are two possible negative effects which should be
carefully concerned and measured by a firm which is
planning to take an international investment project.
Why do we care?
 For example, Robock (1971) suggests the following
operational definition: ... political risk in international
business exists
 (1) when discontinuities occur in the business environment,
 (2) when they are difficult to anticipate, and
 (3) when they result from political change.

To constitute a 'risk' these changes in the business
environment must have the potential for significantly
affecting the profit or other goals of a particular enterprise.
How does political risk affect international
business? - Some Findings
 A positive relationship between foreign direct investment




(FDI) and intellectual property protection. (Lee and
Mansfield, 1996)
A negative impact of corruption on FDI flows. (Wei, 2000)
Harms and Ursprung (2002), Jensen (2003), and Busse
(2004) find that multinational corporations are more likely
to be attracted by countries in which democracy is
respected.
Kobrin (1978) finds the presence of a negative
relationship between political instability and FDI.
The political actions and instability may make it difficult
for companies to operate efficiently in these countries
due to negative publicity and impact created by
individuals in the top government. (Okolo, 2006)
Measuring the Risks
 (1) Political Risk
 Country Risk Rating:
 The number of country risk ratings compiled by commercial
agencies such as Moody’s, Standard and Poor’s,
Euromoney, Institutional Investor, Economist Intelligence
Unit, International Country Risk Guide, Political Risk
Services, Fitch IBCA, Business Environment Risk
Intelligence S.A., S.J. Rundt & Associates, and Control
Risks Group, has increased substantially since the Third
World debt crisis in the early 1980s.
Measuring the Risks
 According to the International Country Risk Guide
(ICRG), its risk ratings have been cited by experts at the
IMF, World Bank, United Nations, and other international
institutions, as a standard against which other ratings
can be measured. The ICRG has been acclaimed by
publications such as Barron’s and The Wall Street
Journal for the strength of its analysis and rating system.
 The ICRG staff collects political, financial, and
economic data, converting these into risk points for
each individual risk component on the basis of a
consistent pattern of evaluation. The following is the
ICRG measurement table of political risk:
ICRG POLITICAL RISK COMPONENTS
Sequence
Component
Points
(max.)
A
Government Stability
12
B
Socioeconomic Conditions
12
C
Investment Profile
12
D
Internal Conflict
12
E
External Conflict
12
F
Corruption
6
G
Military in Politics
6
H
Religious Tensions
6
I
Law and Order
6
J
Ethnic Tensions
6
K
Democratic Accountability
6
L
Bureaucracy Quality
4
Total
100
Measuring the Risks
 (2) Credit Risk:
 Credit Risk Rating: From rating agencies, such as
Moody’s, Standard and Poor’s, Fitch, etc..
 Credit risk models:
 Z-Score Model (Altman, 1968)
 O-Score Model (Ohlson, 1980) – Logistic Model
 BSM Model (Black-Scholes, 1973; Merton, 1974) – Option
Pricing Model
International Investment Decision-Making
under Political Risk and Credit Risk
 Risk Adjusted NPV Method:
CFN
CF1
CF2
NPV   II 

 ... 
2
(1  RADR) (1  RADR)
(1  RADR) N
N

i 1
where
CFi
 II
i
(1  RADR)
CFi
II
RADR
N
is the net cash flow brought by the project at time I
is the initial input for taking the project
is the risk-adjusted discount rate, the expected rate of
the return integrating political risk and credit risk.
is the expected effective time period of the project
International Investment Decision-Making
under Political Risk and Credit Risk
 Capital Budgeting:
 When NPV > 0  Take the project
 When NPV < 0  Reject the project
 When NPVA > NPVB > 0  If budget is limited, take
Project A first.
 Key: RADR
 Different from using expected rate of return which only
concerns about the operating risk as discount rate in the
general NPV model, both political and credit risk should
be adjusted for the discount rate used in the NPV model
when making an international investment decision.
International Investment Decision-Making
under Political Risk and Credit Risk
 Especially for the political risk…
 Since the political risk is a non-project specific risk, from
the definition, it seems to be systematic and unavoidable.
However, diversification is still possible…
Economy A
C
B
A
Conclusions and Suggestions
 How to manage political risk and credit risk for the modern
international business becomes a challenging issue.
Rating agencies and models provide helpful information
and methods to measure the two risks.
 From the perspective of corporations (investors), the key is
to remember to count the negative effects of the two risks
in when making the capital budgeting decisions.
 Especially for the political risk, it is not unavoidable.
Diversification is still possible.
 A challenge is how to more accurately integrate the
measures of the two risks into the capital budgeting
decision measurement.