Political risk is the risk that an investment’s returns could suffer as a result of political changes or volatility in a country. Volatility affecting investment returns could arise from a change in several areas such as government, legislative bodies, other foreign policy makers, or military control. For example, political risk can affect the worth of a corporation with locations in various countries through changes in future cash flows and the required return of investors. The impact of political risk on cash flow is noticeably of interest to managers and investors (Butler & Joaquin, 1998).
To get an idea of the real-world consequences of political causes of risk in cost of capital calculations, the 1987 election in the United Kingdom is …show more content…
The relationship between variations in the Labour Party’s chances of victory and changes in Morgan Stanley Capital International’s United Kingdom stock market index during the campaign was -0.46. Now assume another project has the same expected return result as the United Kingdom stock market to a Labour win equal to -20 percent. The relationship of a negative consequence of political risk with a disparaging market return increases the systematic risk of the project by 0.18. Given a market risk premium of 6 percent, the risk of a Labour win increases the required return on the project by 1.08 percent. For a project requiring an opening investment of $100 million, investors vulnerable to a non-diversifiable risk of a Labour win will require an extra return of $1.08 million each period. The risk of a Labour Party victory is obviously non-diversifiable to an investor with 100 percent of their portfolio invested in United Kingdom assets. To an internationally diversified investor, this particular political cause of risk may or may not be diversifiable. For …show more content…
Even though other types of risks, such as economic and financial risk, have been studied fairly comprehensively, political risk has not received as much attention primarily due to a lack of relevant data. Studies show that most of the political risk signs have an adverse correlation with Foreign Direct Investment, or FDI, throughout the world as a whole, as well as countries with higher income, but that relationship was also the strongest in the countries that are upper to middle income countries. FDI has been a topic of concern for years. The flood of FDI primarily surged in the 1980’s when lending by commercial banks to the emerging economies came to an end, which in turn forced many countries to ease limitations and offer tax incentives and subsidies to draw in foreign capital. FDI positively contributes to the Gross Domestic Product, or GDP, of countries by bringing in foreign exchange reserves, and improving the Balance of Payment, or BOP, of the local economies (Khan & Akbar,
To get an idea of the real-world consequences of political causes of risk in cost of capital calculations, the 1987 election in the United Kingdom is …show more content…
The relationship between variations in the Labour Party’s chances of victory and changes in Morgan Stanley Capital International’s United Kingdom stock market index during the campaign was -0.46. Now assume another project has the same expected return result as the United Kingdom stock market to a Labour win equal to -20 percent. The relationship of a negative consequence of political risk with a disparaging market return increases the systematic risk of the project by 0.18. Given a market risk premium of 6 percent, the risk of a Labour win increases the required return on the project by 1.08 percent. For a project requiring an opening investment of $100 million, investors vulnerable to a non-diversifiable risk of a Labour win will require an extra return of $1.08 million each period. The risk of a Labour Party victory is obviously non-diversifiable to an investor with 100 percent of their portfolio invested in United Kingdom assets. To an internationally diversified investor, this particular political cause of risk may or may not be diversifiable. For …show more content…
Even though other types of risks, such as economic and financial risk, have been studied fairly comprehensively, political risk has not received as much attention primarily due to a lack of relevant data. Studies show that most of the political risk signs have an adverse correlation with Foreign Direct Investment, or FDI, throughout the world as a whole, as well as countries with higher income, but that relationship was also the strongest in the countries that are upper to middle income countries. FDI has been a topic of concern for years. The flood of FDI primarily surged in the 1980’s when lending by commercial banks to the emerging economies came to an end, which in turn forced many countries to ease limitations and offer tax incentives and subsidies to draw in foreign capital. FDI positively contributes to the Gross Domestic Product, or GDP, of countries by bringing in foreign exchange reserves, and improving the Balance of Payment, or BOP, of the local economies (Khan & Akbar,