Country and Political Risk

Definition & Terminology:

• Political risk: the risk that a government action will negatively affect a company's cash flow. Also, the risk that an investment's return could suffer as a result of political changes or instability in a country. Example of risk factors:
• Nationalisation (expropriation): in its extreme form, government seize properties without compensating the owner.
• Contract repudiation: government revoke ("put an end to") contract without compensating companies for their existing investments.
• Taxes and regulations: unexpected increases in taxes, stricter standards.
• Exchange controls: doing business in countries with inconvertible currencies.
• Corruption and legal inefficiency:  Gov. corrupt act and demand biases.
• Ethnic violence, political unrest, and terrorism: internal civil wars.
• Home-country restrictions: a company's home country politics that affect foreign operations.
• Country risk: is a broader concept that encompasses both the potentially adverse effect of a country's political environment, economic and financial environment. Example:
• A recession in a country -- reduces revenues of exporters.
• Labor strike -- lowering profits: disruption in production & distribution of product.
• Clashes between ethnic or religious group.
• Also effects investors who buy emerging market securities, cause a borrowers to default on a loan. Sovereign risk: a risk that government defaults on its bond payments. The ability of a private firm and its government to pay off international debt are highly correlated.
• Financial risk: the possibility that shareholders will lose money when they invest in a company that has debt, company cash flow inadequate to meet their financial obligations.
• Economic risk: macroeconomic conditions will affect an investment (exchange rates, government regulations).

Incorporating political risk in capital budgeting: (1) Adjusting expected cash flows for political risk. (2) Adjusting the discount rates instead of cash flows -- r* = (r+p)/(1-p).
The infinite cash flow: CF*(1-p) / (r+p)

The PRS (Political Risk Services) group's ICRG (International Country Risk Guide): financial and economic factors (assessing country's ability to repay foreign debt, objective information); political risk factors (stability based on government; subjective information).
Risk stability: the difference between the worse and the bast case forecasts as indicator of the volatility of risk.

Credit spreads: the difference between the yield on the bond and the yield on a comparable Treasury Bond that is not subject to default risk.
Country credit spreads: the difference between the yield offered on international bonds and the yields on the government bonds of the developed country issuing the currency.

Managing political risk: focus on the short term; rely on unique supplies or technology (making government takeover more difficult); use local resources; bargain with the government; hire protection.
Insurance: Coverage -- currency inconvertibility and non-transferability;  expropriation; war and political violence; interference with operations. Example: OPIC (Overseas Private Investment Corporation), in emerging and transitioning economy: MIGA (Multilateral Investment Guarantee Agency), public and private insurance.