FINS3616 Lecture Notes - Lecture 10: Corruption Perceptions Index, Capital Budgeting, Foreign Exchange Risk
9 – Country and Political Risk & Capital Budgeting
Country risk
• Political risk – risk that the government will do something bad like expropriate funds
or refuse to pay foreign debt
• Financial and economic risk factors
Ratio of a outr’s eteral det to its GDP
Ratio of a outr’s det servie paets to its eports
Ratio of a outr’s iports to its offiial iteratioal reserves
A outr’s terms of trade (export/ import prices)
A outr’s CAD
• Political risk factors
Expropriation/ nationalisation – worst-cast scenario
Contract repudiation
Taxes and regulation (i.e. hiring/firing, environmental standards, repatriation of
funds)
Exchange controls (e.g. Argentina in 2002)
(a) Limit conversion of domestic for foreign currency to keep the supply of
domestic currency in the forex market in check
Corruption and legal inefficiency
(a) Transparency International Corruption Perceptions Index for >150 countries
(b) Huge problem in developing countries
(c) Poor investor and property rights protection
Ethnic violence, political unrest and terrorism
(a) Yugoslavia 1990s, Ukraine, Yemen, Kenya, Europe
Home-country restriction
(a) US embargo and restrictions on US companies doing business with Iran
Country risk versus political risk
• The Debt Crisis (late 70s, early 80s)
Origins of the debt crisis
(a) Oil and OPEC: prices went from $2.50-60 per barrel (in 2000 dollars)
(b) Anti-inflationary policies had real interest rates high and USD was strong –
repayment of petrodollar loans very difficult
• Mexico announced in 1982 they could not repay their foreign debt; by the end of the
year, 24 other countries followed suit
• Managing the debt crisis – The Baker Plan, 1985
Implemented when IMF debt restruturigs did’t ork, assuptio that
liquidity was the cause of problems
Included new loans by banks/ World Bank in exchange for agreeing to follow
economic advice
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2
Debt overhang problem
• Debt and debt service-reducing operations
Debt buyback (at a discount)
Debt-equity-swap – MNC buys discounted debt to invest in country
(a) After buying the debt, MNC receives local currency and invests in the equity
investment for this country
(b) Helps country and is a cheaper way for companies to invest in developing
nations
• The Brady Plan, 1989 – effectively debt renegotiation
Options available to banks
(a) Buybacks: the debtor country could repurchase part of its debt at an agreed
discount
(b) Discount bond exchange: loans could be exchanged for bonds at an agreed
discount, with bonds yielding a market rate of interest
(c) Par bond exchange: loans could be exchanged at their face value for bonds
yielding a lower interest rate than the one on the original loans
(d) Conversion bonds combined with new money: loans could be exchanged for
bonds at par that yield a market rate; banks had to provide new money in a
fixed proportion of the amount converted
Incorporating political risk in capital budgeting
• Adjusting expected cash flows for political risk (infinite constant cash flows, constant
probability of exploration)
Compute discount rate normally (i.e. without expropriation risk)
Compute a probability distribution of expropriation risks for each future period
Compute an expected NPV based on those
• Adjusting the discount rate instead of cash flows
Discount rates for emerging markets and political risk
(a) r* = (r+p) / (1-p)
Country and political risk analysis
• PRS Groups’ ICRG ratig sste
Financial and economic risk factors – assessig a outry’s aility to repay foreig
debt (objective inputs)
Political risk components – stability based on government (subjective inputs)
Overall ratings
(a) 1-49: very risky
(b) 50-59.9: high risk
(c) 60-69.9: moderate risk
(d) 70-79.9: low risk
(e) 80-100: very low risk
• Country credit spreads
Sovereign credit ratings – Moody’s, S&P, Fith
Why is sovereign credit risk different?
(a) Ca’t take a outry to akrupty ourt
(b) Consequences still in place:
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Document Summary
9 country and political risk & capital budgeting. Country risk: political risk risk that the government will do something bad like expropriate funds or refuse to pay foreign debt, financial and economic risk factors. Ratio of a (cid:272)ou(cid:374)tr(cid:455)"s e(cid:454)ter(cid:374)al de(cid:271)t to its gdp. Ratio of a (cid:272)ou(cid:374)tr(cid:455)"s de(cid:271)t servi(cid:272)e pa(cid:455)(cid:373)e(cid:374)ts to its e(cid:454)ports. Ratio of a (cid:272)ou(cid:374)tr(cid:455)"s i(cid:373)ports to its offi(cid:272)ial i(cid:374)ter(cid:374)atio(cid:374)al reserves. A (cid:272)ou(cid:374)tr(cid:455)"s terms of trade (export/ import prices) A (cid:272)ou(cid:374)tr(cid:455)"s cad: political risk factors. Taxes and regulation (i. e. hiring/firing, environmental standards, repatriation of funds) Exchange controls (e. g. argentina in 2002) (a) limit conversion of domestic for foreign currency to keep the supply of domestic currency in the forex market in check. Corruption and legal inefficiency (a) transparency international corruption perceptions index for >150 countries (b) huge problem in developing countries (c) poor investor and property rights protection. Ethnic violence, political unrest and terrorism (a) yugoslavia 1990s, ukraine, yemen, kenya, europe.
