COUNTRY RISK ANALYSIS

CONTENTS
CRA: Meaning Types of country risks Need/uses of CRA Levels of CRA Types of CRA Developing CRA ratings Comparing ratings among countries Incorporating ratings in Capital Budgeting decisions

Transfer Risk

Macroeconomic Risk

Sovereign Risk

COUNTRY RISK

Indirect Country Risk

Contagion Risk

Currency Risk

CRA : Meaning
Country risk analysis (CRA) deals with how a firm addresses the risks involved in making investments in a foreign country. Country risk is the risk that economic, political, or social conditions and events in a foreign country will adversely affect a firms financial and strategic interests. Decision makers need to weigh any potential loss of invested capital that could result from troublesome circumstances in a foreign country. CRA as a discipline seeks to identify these risks and determine the degree to which they will negatively impact their return on investment (ROI).

ECONOMIC RISK
EXCHANGE RISK LOCATION RISK POLITICAL RISK

COUNTRY RISK

ECONOMIC RISK
Economic risk is the risk associated with less than expected rates of return or performance of an investment stemming from changes in economic policies or growth rate. Economic risk can occur most commonly when: Economic policies change. The goals underlying economic policies change. The market growth rate changes. An economys strengths or advantages are somehow compromised. Material changes in a countrys natural or human resources, demographics, or industry performance can all result in economic risk. Political risk and economic risk may be closely related.

EXCHANGE RISK
Exchange risk generally entails a quick or unexpected movement in the exchange rate between countries that causes detrimental investment results. This can include a country switching from fixed to floating exchange rate systems or vice versa.

LOCATION RISK
These risks exist by virtue of being physically close to an unstable environment. They can occur wherever there are problems in a particular region: problems with a geographically near trading partner, with a neighbouring country, or a country with similar traits or characteristics. For example, religious or racial persecution can lead to a flood of refugees to neighboring countries and cause disruption in commerce and trade.

POLITICAL RISK
These are risks that result from political changes. Political risk can be further divided into two categories: societal and governmental. Societal risk refers to instability caused by civil wars, terrorism, dramatic shifts in societal values, pressures by powerful unions, religious disagreements, revolutions, national work stoppages, or any other politically charged civil event that is detrimental to the activities of a foreign firm. Governmental risk encompasses all actions by the host government that can have negative effects on foreign businesses. These include nationalization and expropriation, limits on the repatriation of assets and profits, a dramatic change in leadership, and/or general bureaucracy.

CRA : Needs/Uses
To monitor countries where the MNC is presently doing business; As a screening device to avoid conducting business in countries with excessive risk; and To improve the analysis used in making long-term investment or financing decisions.

Country Risk Analysis

CRA : Levels
A macro-assessment of country risk is an overall risk
assessment of a country without consideration of the MNCs business.

A micro-assessment of country risk is the risk

assessment of a country as related to the MNCs type of business.

CRA: Types
Opinions of different risk analysts often differ due to subjectivities in:
identifying the relevant political and financial factors, determining the relative importance of each factor, and predicting the values of factors that cannot be measured objectively.

CRA: Types/Techniques
A checklist approach involves rating and weighting all the
identified factors, and then consolidating the rates and weights to produce an overall assessment.

The Delphi technique involves collecting various

independent opinions and then averaging and measuring the dispersion of those opinions.

CRA: Types/Techniques
Quantitative analysis techniques like regression analysis
can be applied to historical data to assess the sensitivity of a business to various risk factors.

Inspection visits involve traveling to a country and meeting

with government officials, firm executives, and/or consumers to clarify uncertainties. Combination of techniques - many firms use a variety of techniques for making country risk assessments. For example, they may use a checklist approach to develop an overall country risk rating, and some of the other techniques to assign ratings to the factors considered.

DEVELOPING CRA RATING: Steps

Assign values and weights to the various risk factors. Assign weights to the political, economic, exchange and

location risk factors according to their perceived importance. Multiply the factor values with their respective weights, and sum up to give the rating to each type of risk. Derive the rating for each type of risk similarly. Sum up the ratings given to each type of risk to derive the overall country risk rating.

Developing CRA Rating

Different country risk analysts have their own individual

procedures for quantifying country risk.

Although most procedures involve rating and weighting

individual risk factors, the number, type, rating, and weighting of the factors will vary with the country being assessed, as well as the type of corporate operations being planned.

Developing CRA Rating

Firms may use country risk ratings when screening potential

projects, or when monitoring existing projects.

For example, decisions regarding subsidiary expansion, fund

transfers to the parent, and sources of financing, can all be affected by changes in the country risk rating.

Comparing Risk Ratings Among Countries

One approach to comparing political and financial ratings

among countries is the foreign investment risk matrix (FIRM ).

The matrix measures financial (or economic) risk on one axis

and political risk on the other axis.

Each country can be positioned on the matrix based on its

political and financial ratings.

Comparing Risk Ratings Among Countries

Some countries are rated higher according to some risk factors,

but lower according to others.

On the whole, industrialized countries tend to be rated highly,

while emerging countries tend to have lower risk ratings.

Country risk ratings change over time in response to changes in

the risk factors.

Incorporating Country Risk in Capital Budgeting

If the risk rating of a country is in the acceptable zone, the

projects related to that country are selected for further consideration.

Country risk can be incorporated into the capital budgeting

analysis of a project -by adjusting the discount rate, or -by adjusting the estimated cash flows.

Incorporating Country Risk in Capital Budgeting

Adjustment of the Discount Rate

The higher the perceived risk, the higher the discount rate that should be applied to the projects cash flows.
Adjustment of the Estimated Cash Flows

By estimating how the cash flows could be affected by each form of risk, the MNC can determine the probability distribution of the net present value of the project.