Can Country Risk Analysis Be Quantified - Essay Example

Country Risk Analysis (CRA) Introduction: Country Risk Analysis (CRA) recognizes asymmetries that step-up the risk of a deficit in the likely return of an investment across the borders. Every business transaction does carry certain degree of risk with it. If it is an international business there involves some additional risks as well. These additional risks are known as country risks. Country risks may include risks arising out of policies, topography, currencies, socio-political institutions, differences in economic structure of the country etc. Country risk analysis tries to identify the possibility for these risks which may decrease the expected return (Sergey Krivovichev, Peter Burns, Ivan Tananaev, 2007). Risk aids an analyst to identify an event drawn from large samples of observations. These samples of observations help analysts to develop a statistical function which is open to probability analysis. Most of the events which are individually investigated by country risk analysis will come down closer to doubts rather than clear statistical risks. This drives the analysts to build risk channels from judgmental or theoretical foundations and may not be probabilistic. Analysts of CRA, deal with soft nature of the risk in varied ways. This results in broad views of the level of risk of a country. Country risk analysis depends upon the basic principle that increasing instabilities in social, political or economic components augment the risk of a deficit in the anticipated payoff on an investment. Imbalances in a particular risk factor represent one or more risk classes. Mapping all the elements at proper level of control produces a general assessment of venture risk. The structure of mapping varies with the type of investment giving rise to an imbalance in a given factor creating different risks for different investments. Unfortunately there is no all-inclusive theory which can guide the procedure of mapping the process in a country risk analysis (Sabal J., 2002). Country risk services build their risk measures with the help of an assorted mix of socio-political or economic indicants established on the choice of standards. These standards are developed out of analysts’ knowledge, experience and judgment. The services generally merge a range of factors indicating real and possible imbalances into a complete risk assessment which applies to a wide range of investment classes. Different Categories of Country Risk Analysis and their Measurements: (Damodaran A., 2003) Analysts have separated country risk into 6 major categories. But many of these categories overlap each other. Although most of the risk analysts do not agree with this list; these 6 constructs can be seen in risk ratings of virtually every service as seen below. Economic Risk Risk arising from Transfer Rate of Exchange Risk Location or Neighbourhood Risk Sovereign Risk Risk due to Political situations of a country Uses of a Country risk analysis: A Country risk analysis can be utilized for the following purposes: To watch countries where the MNC has its present business. To avoid doing business in a country which has excessive risk. The investments to be revised depending on the current events of the country. Should Country Risk be quantified? Yes, country risk has to be quantified. The quantification of a country risk will help the investors to calculate the cash flow out of their investments. Investments can be based on the returns only if a value of country risk can be calculated. Since country risk is embedded in a very particular way in every business an isolation of the risk is not practically possible. But the nature of country risk is of course detrimental but at the same time beneficial also. For example, the charges of a water service can be exceedingly low when there is social unrest which harms the profit of the firm. In contrast, low subsidized energy costs would concede abnormal high returns to certain manufacturers. Apart from this country risk analysis is an efficient tool to determine the interest of instituting a constructing site or any other method of entry. A company is prone to expire if it brushes off its markets. Closing its accounts payable is a simple and single way to live to tell the tale of a storm. Using imaginative accounting to rationalize neglecting its payables can be another way to survive the storm. But this strategy is neither digested nor allowed where laws are customary and pragmatic. But with the increase of Country Risk Analysis (CRA), it can be indicated that such exercises have been theoretically legalized. It renders the best overview of the circumstance of a certain place. If the rank is not so good, then it is better to go deeper into the analysis of the condition - at sector and local level. Not only economic aspects are to be concerned but also social, political, and environmental factors are to be analysed. Why should Country Risk be quantified? CRA gives a picture and an unsophisticated index to be evaluated and equated with, from an investors viewpoint. CRA interprets qualitative and quantitative analysis into a single score, so that there is no requirement to get into profound prejudiced analysis for depicting comparisons between two or more countries. It constricts a range of information of a country into a single constraint which can be easily understood. It can be thus conveniently utilized for a decision building process which involves comparison among different countries. Even though there is no agreement with regard to the best method for assessing country risk, some strategy has been formulated. The initial step is to be acquainted with the difference between (i) the complete risk assessment of a country without considering the business of MNCs, and (ii) the risk appraisal of a country as it pertains to the style of business of MNCs. Credit decisions are normally established on composite weighted element which includes economic, political, and social factors. “For example, chances of a military coup could rate a 1 (if a peaceful, bloodless coup) or significantly higher if the civilian government is removed with considerable resistance and bloodshed (resulting in, say, a 10). Economic stability based on a weak or strong economic infrastructure, volatile commodity based foreign sales (extracted minerals, wheat) affects the rating yet again. As for social factors (civil society), these can influence ratings on the basis of tolerance of corruption and nepotism in society, with its inevitable crossover effect into business. The more corrupt the society, the higher the cost of doing business, the lower the efficiency of output, and the lower the return on investment (ROI) for the foreign direct investor” ( Beeching Peter, 2008 ) The choice of statistical data is crucial in CRA(The journal of investing, 2002) A scientific research for that matter any kind of research work depending on statistical data can result in incorrect results or in common become pointless, if it is founded on inaccurate data. The right selection of the source of the information in economic science is in particular very crucial, since more often than not local statistical data disagree from the external statistics. Collective Risk Measures: Country risk analysis during the seventies and eighties were concentrated on risks which banks and other private agencies received when they lent currency loan to an autonomous government of a foreign country (Damodaran A., 2003). Risks were sectioned to discover possible shortfalls in either the foreign money value of the venture or in the local currency of the investor. Quantitative risk analysis normally centred on factors connected to the capability of a country to make foreign currency to pay back the debt. The variance (VAR) parametric approach: VAR is a mode of calculating country market risk that makes use of standard statistical techniques. VAR calculates the most awful predictable loss for a given time interval and when the market condition is normal at a known confidence level. The standard deviation of the daily return is used to estimate the profit or loss which the firm may earn. While assuming that the payoff of a financial produce follows normal distribution, linear return account and straight relationship between the fundamental product and the income, the VAR is to be measured by the standard deviation of the income at a presumed confidence level. In certainty, the VAR is an estimate of the standard deviation. Though the technique depends on numerous presumptions and has been deeply criticised and is frequently admonished, it has received broad recognition for the quantification of country risk analysis within the different financial trading units. “A financial entity might say that the daily VAR of its trading portfolio is $1 million at the 99 per cent confidence level. This means, there is only one chance in a hundred (or one day in every 100 trading days), under normal market conditions, for a loss greater than $1 million to occur. This single number summarizes the exposure of the bank to market risk as well as the probability of an adverse move. Equally important is that, it measures risk using the same units as the banks bottom line — dollars. Shareholders and managers can then decide whether they feel comfortable with this level of risk. If the answer is no, the process that led to the computation of VAR can be used to decide where to trim the risk. While this method is powerful for day-to-day risk management, it is no substitute for the wider risk management process of analysing crash scenarios and keeping control on operational and legal risks”(Journal of Derivatives & Hedge Funds, 2007) Bank and country risk analysis calls forth risk appraisal developing to a novel level. Bank and country risk, when understood and assessed both quantitatively and qualitatively tells about the importance of country risk analysis to bankers, investors and regulators and this has altered over the recent years. (http://www.bharatbook.com/contact.php) Conclusion: (Journal of Derivatives & Hedge Funds, 2007) An understanding of country risk has increasingly become important in the global nature of investment portfolios. A lot of empirical work has gone into figuring out the risk measures and evaluate decisions. Therefore, it is critical to simplify the interpretation from an investor’s standpoint. Thus risk can be quantified. But when risk is quantified with the use of pure mathematical models there is always a danger involved. In fact risk analysis depends upon the capacity of the strategist to show a relationship clinically which becomes the foundation for market entry decisions. The sine qua non is that no value is unique for a firm, and this sta­tement is even firmer in extremely coming forth volatile markets. A logically based decision with regard to a reasonable price range can be the best a capitalist can do in volatile markets. If this method has to work effectively, correct trading positions have to be gathered and historical databases have to be built. As soon as the data are centralised, the full risk can be calculated by summing up the risks that may arise from individual contracts throughout the group. VAR can be measured from the relationships between the individual risk factors and the effect on the portfolio of moves in each risk factor. “Many financial institutions have chosen a confidence interval of 95 per cent (or 97.5 per cent if we only look at the loss side (one-tailed)) to calculate VAR. This means that once in every 40 trading days, a loss larger than the indicated is expected to occur. Some banks use a 99 per cent confidence interval, which will lead to larger loss per hundred trading days. Owing to fat tails of the probability distribution, such a loss will occur more often. Some financial institutions feel that the usage of a 99 per cent confidence interval would place too much trust on the statistical model and, hence, some confidence level should be assigned to the art–side of the risk measurement process.” (Journal of Derivatives & Hedge Funds, 2007). The globalisations of economies of the world and financial markets have radically extended several investment possibilities, leading to various novel opportunities, followed by new risks. Subsequently, there is rising interest in getting consistent estimates of the risk of investment in different countries. These fears have contributed to the growth of the notion of country risk, and eventually increasing the regular publication of country risk evaluations by different agencies. The significance of ratings has been exaggerated by the testimonials which are addressed in the (Basel Capital Accord, 2001) that nails the position of agencies’ ratings for the appraisal of country risk analysis. Thus it can be said that country risk analysis has to be quantified and that too following a mathematical mode of quantifying the risk. “A customer whose country of origin is a high-risk country may still be a good customer. For example, if the applicant is a naturalized citizen, the risk of their country of national origin is not relevant. To take that risk into account could only be construed as discrimination. On the other hand, an individual in this country on a temporary visa should be evaluated in the context of the expected time in this country relative to the credit requested” (Bankersonline, 2002) So it is concluded that country risk analysis is not a simple and easy task as it seems to be. It requires a vision of holism, dedicated skills and relentless approach. The analyst has to follow standard operations to guarantee cohesiveness in his research, by means of dependable and valuable sources of data, as well as rating agencies, official establishments and many other several generators. After considering the socio-political, macroeconomic, and financial views, the study has to display the strength and weakness of a country, so that risk at a certain level can be defined on a connected price for the asset in risk. Organizing the risk of an investment requires a methodical follow up relating to governmental policies, outer and inner environment, and of course, the outlook rendered by the rating agencies, and so on. References: 1 http://www.bankersonline.com/articles/v07n05/v07n05a18.html 2. Damodaran A. 2003, “Country Risk and Company Exposure: Theory and Practice”, Journal of Applied Finance, Fall. 3. Sergey Krivovichev, Peter Burns, Ivan Tananaev, “Risk Quantification: Management, Diagnosis and Hedging” Wiley (February 2, 2007) | ISBN: 0470019077 | 286 pages | PDF | 2,7 Mb 4. Moodys Credit Training Global Credit & Risk Training for Bankers, Risk Analysts & Investors 5. http://www.iijournals.com/JOI/default.asp?Page=2&ISS=8240&SID=319523 6. Erb C., Harvey C., Viskanta T. 1995, “Inflation and World Equity Selection”, Financial Analysts Journal, November-December. 7. Erb C., Harvey C., Viskanta T. 1996“Political Risk, Economic Risk and Financial Risk”, Financial Ana­lysts Journal, November-December. 8. Sabal J. 2002, “Financial Decisions in Emerging Markets”, Oxford University Press. 9. Sabal J. 2004, “The Discount Rate in Emerging Markets: A Guide”, Journal of Applied Corporate Finance, Summer. 10. Beeching Peter 2008, “Country Risk Analysis: 50 Ways...” Canadian Underwriter 11. http://www.palgrave-journals.com/jdhf/journal/v13/n1/full/1850059a.html 12. http://www.bharatbook.com/contact.php Read More