PET ENGINEERING COLLEGE

ISO 9001:2015 Certified Institution

Accredited by NAAC, Approved by AICTE, Recognized by Government ofTamil Nadu and

Affiliated to Anna UniversityVallioor-627117

DEPARTMENT OF MANAGEMENT STUDIES

UNIT - 5

CLASS : S3 MBA

SUBJECT CODE : BA 4006

SUBJECT NAME : INTERNATIONAL FINANCE

REGULATION : 2021

STAFF IN CHARGE : Mr. N. Vajith Rahuman

UNIT -5: INTERNATIONAL RISK ASSESSMENT AND OTHER INTERNATIONAL
MARKETS
5.1Country And Political Risk Analysis :
Country risk represents the potentially adverse impact of a country’s environment
on an MNC’s cash flows. An MNC conducts country risk analysis when it applies capital
budgeting to determine whether to implement a new project in a particular country or
whether to continue conducting business in a particular country. Financial managers must
understand how to measure country risk and incorporate country risk within their capital
budgeting analysis so that they can make investment decisions that maximize their MNC’s
value.
COUNTRY RISK CHARACTERISTICS
Country risk characteristics can be partitioned as political or financial.
Political Risk Characteristics:
Political risk can impede the performance of a local subsidiary. An extreme form of political
risk is the possibility that the host country will take over a subsidiary. In some cases of
expropriation, compensation (the amount decided by the host country government) is
awarded. In other cases, the assets are confiscated, and no compensation is provided.
Expropriation can take place peacefully or by force. The following are some of the more
common characteristics of political risk:
■ Attitude of consumers in the host country
■ Actions of host government
■ Blockage of fund transfers
■ Currency inconvertibility
■ War
■ Inefficient bureaucracy
■ Corruption
Each of these characteristics is discussed in turn.
Attitude of Consumers in the Host Country
A mild form of political risk (to an exporter) is a tendency of residents to
purchase only locally produced goods. Even if the exporter decides to set up a subsidiary in
the foreign country, this philosophy could prevent its success. All countries tend to exert
some pressure on consumers to purchase from locally owned manufacturers. MNCs that
consider entering a foreign market (or have already entered that market) must monitor the
general loyalty of consumers toward locally produced products. If consumers are very loyal
to local products, a joint venture with a local company may be more feasible than an
exporting strategy.
Actions of Host Government
Various actions of a host government can affect the cash flow of an MNC. A host
government might impose pollution control standards and additional corporate taxes, holding
taxes and fund transfer restrictions.
Some MNCs use turnover in government members or philosophy as a proxy for a country’s
political risk. While such change can significantly influence the MNC’s future cash flows, it
alone does not serve as a suitable representation of political risk. A subsidiary will not
necessarily be affected by changing governments. Furthermore, a subsidiary can be affected
by new policies of the host government or by a changed attitude toward the subsidiary’s
home country (and therefore the subsidiary), even when the host government has no risk of
being overthrown.
Blockage of Fund Transfers
Subsidiaries of MNCs often send funds back to headquarters for loan repayments, purchases
of supplies, administrative fees, remitted earnings, or other purposes. In some cases, a host
government may block fund transfers, which could force subsidiaries to undertake projects
that are not optimal.
Currency Inconvertibility
Some governments do not allow the home currency to be exchanged into other currencies.
Thus, the earnings generated by a subsidiary in these countries cannot be remitted to the
parent through currency conversion. When the currency is inconvertible, an MNC’s parent
may need to exchange it for goods to extract benefits from projects in that country
War
Some countries tend to engage in constant conflicts with neigh boring countries or
experience internal turmoil. This can affect the safety of employees hired by an MNC’s
subsidiary or by salespeople who attempt to establish export markets for the MNC
Inefficient Bureaucracy
Another country risk factor is a government’s bureaucracy, which can complicate an MNC’s
business. Although this factor may seem irrelevant, it has been a major deterrent for MNCs
that consider projects in various emerging countries. Bureaucracy can delay an MNC’s
efforts to establish a new subsidiary or expand business in a country.
Corruption
Corruption can adversely affect an MNC’s international business because it can increase the
cost of conducting business or reduce revenue. Various forms of corruption can occur at the
firm level or with firm-government interactions. For example, an MNC may lose revenue
because a government contract is awarded to a local firm that paid off a government official.
FINANCIAL RISK CHARACTERISTICS
Along with political characteristics, financial characteristics should be considered when
assessing country risk. Financial characteristics can have a strong impact on international
projects that MNCs have proposed or implemented
Economic Growth
One of the most obvious financial characteristics is the current and potential state of the
country’s economy. An MNC that exports to a country or develops a subsidiary in a country
is very concerned about that country’s demand for its products, which is influenced by the
country’s economy. A recession in the country could severely reduce demand for the MNC’s
exports or for products sold by the MNC’s local subsidiary.
A country’s economic growth is influenced by interest rates, exchange rates, and inflation,
which are discussed in turn.
 Interest rates. Higher interest rates tend to slow the growth of an economy and reduce
demand for the MNC’s products. Governments commonly attempt to maintain low
interest rates when they want to stimulate the economy. Low interest rates can
encourage more borrowing by firms and consumers, and result in more spending.
However, during and after the recent financial crisis, low interest rates had limited
effects because many firms and consumers were already at their debt capacity and
were not in a position to borrow more funds.
 Exchange rates. Exchange rates can influence the demand for the country’s exports,
which affects the country’s production and income level. A strong currency may
reduce demand for the country’s exports, increase the volume of products imported by
the country, and therefore reduce the country’s production and national income.
 Inflation. Inflation can affect consumers’ purchasing power and their demand for an
MNC’s goods. It affects the expenses associated with operations in the country. It may
also influence a country’s financial condition by influencing the country’s interest
rates and currency value.
BENEFITS AND RISKS OF INTERNATIONAL PORTFOLIO INVESTMENT

What is Foreign Portfolio Investment (FPI)?

Foreign portfolio investment (FPI) involves an investor purchasing foreign financial assets.
The transaction of foreign securities generally occurs at an organized formal securities
exchange or through an over-the-counter market transaction.

Foreign portfolio investment is becoming increasingly more common as a means of portfolio

diversification. Often, FPIs consist of securities and alternative foreign financial assets that
are passively held by a foreign investor.

Who Can Make Foreign Portfolio Investments?

Foreign portfolio investing is popular among several different types of investors. Common
transactors of foreign portfolio investment include:
 Individuals
 Companies
 Foreign governments.
BENEFITS OF FOREIGN PORTFOLIO INVESTMENT

The primary benefits of foreign portfolio investment are:

1. Portfolio diversification

Foreign portfolio investment provides investors with an easy opportunity to diversify their
portfolio internationally. An investor would diversify their investment portfolio to achieve a
higher risk-adjusted return, which is ultimately done to help generate alpha.

2. International credit

Investors may be able to access an increased amount of credit in foreign countries, allowing
the investor to utilize more leverage and generate a higher return on their equity investment.

3. Access to markets with different risk-return characteristics

If investors are seeking out greater returns, they must be willing to take on greater risk.
Emerging markets can offer investors a different risk-return profile.

4. Increases the liquidity of domestic capital markets

As markets become more liquid, they become deeper and broader, and a wider range of
investments can be financed. Savers can invest with the assurance that they will be able to
manage their portfolio or sell their financial securities quickly if they need access to their
savings.

5. Promotes the development of equity markets

Increased competition for financing will lead to the market rewarding superior performance,
prospects, and corporate governance. As the market’s liquidity and functionality develop,
equity prices will become value-relevant for investors, ultimately driving market efficiency.

RISKS OF FOREIGN PORTFOLIO INVESTMENT (FPI)

The primary risks faced by a foreign portfolio investor are:

Volatile asset pricing

Across international financial markets, some are riskier than others. For example, consider
the Deutscher Aktienindex (DAX). The DAX is a stock market index of 30 major German
companies trading on the Frankfurt Stock Exchange. The DAX is historically more volatile
than the S&P 500 Index.. 2.

Jurisdictional risk
Jurisdictional risk can result from investing in a foreign country. For example, if a foreign
country that you were invested in drastically changes its laws, it could result in a material
impact on the investment’s returns.

Moreover, many countries struggle with financial crime, such as money laundering.
Investing in countries where money laundering is prevalent increases the jurisdictional risk
faced by the investor.

Financial Assets for Foreign Portfolio Investments

The typical financial assets that can be purchased through foreign portfolio investment
include equities, bonds, and derivative instruments. These securities can be purchased for
many reasons; however, generally, foreign portfolio investment is positively influenced by
high rates of return and reduction of risk through geographic diversification.

Policies for Foreign Portfolio Investment

Foreign portfolio investment is inherently volatile, and rigorously regulated financial

markets are needed to manage the risk effectively. Furthermore, the financial system must be
capable of identifying and mitigating risks for prudent and efficient allocation of foreign or
domestic capital flows.

Economic growth and development are enabled by successful financial intermediation and
the efficient allocation of credit. Financial systems can maintain their health through the
identification and management of business risks. Moreover, the financial system must also
withstand economic shocks.

ASSESSING COUNTRY CREDITWORTHINESS

A sovereign credit rating is an assessment of a country’s creditworthiness. It shows the level

of risk associated with lending to a particular country since it is applied to all bonds issued
by the government.

When evaluating the creditworthiness of a country, credit rating agencies consider various
factors such as the political environment, economic status, and its creditworthiness to assign
an appropriate credit rating.

Obtaining a good credit rating is important for a country that wants to access funding for
development projects in the international bond market. Also, countries with a good credit
rating can attract foreign direct investments.

FUTURES MARKETS AND INSTRUMENTS

The forward market facilitates the trading of forward contracts on currencies. A
forward contract is an agreement between a corporation and a financial institution (such as a
commercial bank) to exchange a specified amount of a currency at a specified exchange rate
(called the forward rate) on a specified date in the future.
The most common forward contracts are for 30, 60, 90, 180, and 360 days, although other
periods (including longer periods) are available. The forward rate of a given currency will
typically vary with the length (number of days) of the forward period.

CURRENCY FUTURES MARKET

Currency futures contracts are contracts specifying a standard volume of a particular

currency to be exchanged on a specific settlement date. Thus, currency futures contracts are
similar to forward contracts in terms of their obligation, but differ from forward contracts in
the way they are traded.

Contract Specifications

Currency futures are commonly traded at the Chicago Mercantile Exchange (CME), which
is part of CME Group. Currency futures are available for 19 currencies at the CME.

The typical currency futures contract is based on a currency value in terms of U.S. dollars.
However, futures contracts are also available on some cross-rates, such as the exchange rate
between the Australian dollar and the Canadian dollar. Thus, speculators who expect that the
Australian dollar will move substantially against the Canadian dollar can take a futures
position to capitalize on their expectations.

Trading Currency Futures

Firms or individuals can execute orders for currency futures contracts by calling brokerage
firms that serve as intermediaries. The order to buy or sell a currency futures contract for a
specific currency and a specific settlement date is communicated to the brokerage firm,
which in turn communicates the order to the CME.

Trading Platforms for Currency Futures

There are electronic trading platforms that facilitate the trading of currency futures. These
platforms serve as a broker, as they execute the trades desired. The platform typically sets
quotes for currency futures based on an ask price at which one can buy a specified currency
for a specified settlement date and a bid price at which one can sell a specified currency.
Users of the platforms incur a fee in the form of a difference between the bid and ask prices.

Comparison to Forward Contracts

Basic Differences between Forward and Futures Contracts

1. Trading:
Forward contracts are traded by telephone or telex.
Futures contracts are traded in a competive area.
2. Regulation:
The forward market is self-regulating.
The IMM is regulated by the Commodity Futures Trading Commission.
3.Size of Contract:
Forward contracts are individually tailored and tend to be much larger than the
standardize contracts on the futures market.
 Futures contracts are standardized in terms of currency amount.
4.Delivery Date:
Banks offer forward contracts for delivery on any date.
IMM futures contracts are available for delivery on only a few specified dates a
year.
5.Quotes:
Forward prices generally are quoted in European terms (units of local currency per
U.S. dollar).
Futures contracts are quoted in American terms (dollars per one foreign currency
unit).
6.Transaction Costs:
Costs of forward contracts are based on bid-ask spread.
Futures contracts entail brokerage fees for buy and sell orders.

CURRENCY OPTIONS:

Currency options provide the right to purchase or sell currencies at specified prices. They are
available for many currencies, including the Australian dollar, British pound, Brazilian real,
Canadian dollar, euro, Japanese yen, Mexican peso, New Zealand dollar, Russian ruble ,
South African rand, and Swiss franc. Currency options are classified as either calls or puts
option.