DEPARTMENT OF BUSINESS ADMINISTRATION ASSAM UNIVERSITY

SILCHAR

FM-3105International Financial Management

A Detailed Study on

Currency and Political Risk Analysis & management

Submitted to

Dr. AMRIT LAL GHOSHAssociate Professor

DBA-SMS

Submitted by

Param Kumar Das Roll No: 77

MBA 4th SemesterBatch: 2009-2011

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DECLARATION

I am Param Kumar Das hereby declare that the report namely “A

DETAILED STUDY ON CURRENCY AND POLITICAL RISK

ANALYSIS & MANAGEMNET” prepared by me is an original work,

is the result of independent research carried out by us in partial

fulfillment of the MBA program of ASSAM UNIVERSITY, Silchar. To

the best of our knowledge and belief, this research is an original peace of

our work and is the sheer outcome of our efforts and has not been

submitted to any other University or Institution for the award of any

degree or diploma.

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CHAPTER – 1 INTRODUCTION Page No. CURRENCY RISK 2-3

POLITICAL RISK 3-4

CHAPTER-2 RESEARCH METHODOLOGY

Research Methodology 6

CHAPTER-3 ANALYSIS AND MANAGEMENT

TYPES OF CURRENCY RISK 8

MANAGEMENT OF CURRENCY RISK 9

MANAGING CURRENCY RISK WITH DERIVATIVES 10

POLITICAL RISK ASSESSMENT 13

MEASURING OF POLITICAL RISK 15

MANAGEMENT OF POLITICAL RISK 17

Bibliography 22

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CONTENTS

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CHAPTER-1

INTRODUCTION

CURRENCY RISK

Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

In practice , a business will find that at the time of payments or receipts in cross border deals viz imports, exports, borrowing, lending, investments, the exchange rates are not necessarily as predicted, despite the use of the best and/or all of the methods for forecasting of exchange rates. Businesses therefore, always have an uncertainty, arising out of exchange rate fluctuations, as to the quantum of cash inflows and outflows in a given period. This uncertainty is called the currency risk.

For example, if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the U.S. dollar. So, if you realize a 15% return in your Canadian stocks but the Canadian dollar depreciates 15% against the U.S. dollar, this will amount to no gain at all.

Currency risks represent the degree of potential that any given investment or adjustment to the business operations of a company could be impacted by some change in exchange rates. The exact nature of the currency risk could be considered to be very low and thus well worth the risk in light of the chance for a high return. At the same time, a currency risk that is considered to be somewhat high could be sufficient reason to hold off on making the investment or implementing the change to the business operation.

Sometimes referred to as an exchange rate risk, the currency risk often involves the task of converting one type of currency into another type of currency in order to engage in a given investment. For example, a company may be considering the purchase of a competitor that is based in and operates primarily in a different country. When this is the case, it may be necessary to convert the currency used for the purchase into the type of currency used in the country where the purchased corporation is physically located. The exchange rate involved in making the conversion may indicate that the time for the purchase is not right, and the acquisition should be delayed.

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A currency risk can also impact investors as well. This is especially true for investors who routinely choose to dabble in investment opportunities that involve international components. Once again, the rate of exchange between one currency to another could indicate that the current strength of the base currency is such that the exchange will ultimately put the investor at a disadvantage. When this is the case, the investment should be delayed. However, exchange rates and other pertinent factors can and do change over time, so the investor should consider revisiting the exchange at a later date and determine if the currency risk is now within acceptable perimeters.

POLITICAL RISK

Political risk is the risk associated with doing business in or with other country having different culture, laws, traditions, customs and having a different currency. Political risk is a type of risk faced by investors, corporations, and governments. It is a risk that can be understood and managed with reasoned foresight and investment.

The risk that an investment’s returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers, or military control.  Political risk is also known as "geopolitical risk", and becomes more of a factor as the time horizon of an investment gets longer. Political risks are notoriously hard to quantify because there are limited sample sizes or case studies when discussing an individual nation. Some political risks can be insured against through international agencies or other government bodies.

 

The outcome of a political risk could drag down investment returns or even go so far as to remove the ability to withdraw capital from an investment.

The exercise of political power is the root cause of political risks in international business. How political power is exercised determines whether government action

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threatens a firm's value. For example, a dramatic political event may pose little risk to a multinational enterprise, while subtle policy changes can greatly impact a firm's performance. A student-led protest for political change may not change the investment climate at all, while a change in local tax law can erode a firm's profits very quickly. It is the task of the risk manager or company CFO to identify whether a government action poses a threat to a firm's financial well-being.

The first distinction that must be made is between firm-specific political risks and country-specific political risks. Firm-specific political risks are risks directed at a particular company and are, by nature, discriminatory. For instance, the risk that a government will nullify its contract with a given firm or that a terrorist group will target the firm's physical operations are firm-specific. By contrast, country-specific political risks are not directed at a firm, but are countrywide, and may affect firm performance. Examples include a government's decision to forbid currency transfers or the outbreak of a civil war within the host country.

Firms may be able to reduce both the likelihood and impact of firm-specific risks by incorporating strong arbitration language into a contract or by enhancing on-site security to protect against terrorist attacks. By contrast, firms usually have little control over the impact of country-level political risks on their operations. The only sure way to avoid country-level political risks is to stop operating in the country in question.

There is a second distinction to be made between types of political risk: government risks and instability risks. Government risks are those that arise from the actions of a governmental authority, whether that authority is used legally or not. A legitimately enacted tax hike or an extortion ring that is allowed to operate and is led by a local police chief may both be considered government risks. Indeed, many government risks, particularly those that are firm-specific, contain an ambiguous mixture of legal and illegal elements. Instability risks, on the other hand, arise from political power struggles. These conflicts could be between members of a government fighting over succession, or mass riots in response to deteriorating social conditions.

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CHAPTER-2

RSEARCH METHODOLOGY

Project Title: “A study on Currency risk and Political risk analysis & management”

Name of the Institution: Department of Business Administration, Assam University, Silchar.

Objectives of the Study:

To study the basic concept of currency and political risk

To know the process and steps in the management of currency and political risk

Type of research: In this project descriptive research methodologies were used

Data Source: In this report the study is done on the basis of secondary data sources.

Limitations of the Study:

Time was also the major constraints of the study.

The analysis was purely based on the secondary data. So, any error in theSecondary data might also affect the study undertaken.

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CHAPTER-3

Analysis and Management

TYPES OF CURRENCY RISK

Transaction risk is the risk that exchange rates will change unfavorably over time. Transaction risk depends on the nature of the transaction e.g. whether the company is primarily an importer or exporter or both. It can be hedged against using forward currency contracts;

Translation risk arises when the functional currency used in various transactions, e.g. US Dollar or Great Britain Pound or Japanese Yen, is different from the reporting currency, which in the Indian context is the Indian rupee. Transaction risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.

Economic risk is the aspect of currency risk is the impact of exchange rates on future cash flows of the company. It is based on the extent to which the value of the firm is measured by the present value of its expected future cash flow will change when exchange rates fluctuates unexpectedly. Economic risk is a nebulous term with a variety of definitions. In a nutshell, economic risk is the risk that an endeavor will be economically unsustainable, for a variety of reasons ranging from a change in economic trends to fraudulent activities which ruin the outcome of the project. Before starting projects, economic risk has to be considered to determine whether or not the potential risks are outweighed by the benefits

Political risk arises when a company transacting in a foreign country may find its assets in that country frozen or even confiscated or it may find that the country has prohibited its currency from being convertible. Such an eventuality will prohibit the asset from being taken out of that country. Similarly a country could increase the taxes that businesses are required to pay, thereby reducing the amount repatriable to home country. Another aspect of country risk is the legal jurisdictions to which transaction are subjected.

Interest Rate Risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.

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The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixed income securities with different durations) or hedging (e.g. through an interest rate swap.

MANAGEMENT OF CURRENCY RISK

Currency risk can be termed a sudden fall in the value of a particular currency. This happens due to unexpected shifts in the currency exchange rates. To avoid or minimize losses caused by these incidents, proper currency risk management strategy is very essential. Currency risks are related to the floating exchange rates. The currency exchanges are done for a number of reasons. Nowadays, cross border commercial activities are growing at a rapid pace. Almost everything starting from goods to technologies are exchanged between the traders of different countries. These transactions are subjected to currency risk because floating exchange rates are minimizing the chances of fixing the value of a particular currency.

On the other hand, there are the forex market traders who are involved in trading of currencies of different countries. These traders participate in the activities of one of the most liquid world financial markets. 

A large number of banks, individuals as well as several national governments are involved in these activities. These institutions as well as the individual investors are also in need of currency risk management because the forex market rates and trends change very quickly. 

Two types of risks are managed by currency risk management strategies. These are the systematic risk and unsystematic risk.

Systematic risks are all those risks that affect each and every kind of investments. Interest rate risk, market risk as well as inflation risk, all are considered as systematic risks. On the other hand, there are the unsystematic risks like business and financial risk. Unsystematic risk affects some definite businesses and not the entire market. 

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One of the most common currency risk management tool is the forward exchange contract. According to these contracts that are signed between the potential seller and purchaser of a particular currency, the exchange rates are fixed before the actual transaction. The transaction takes place in the future but due to the contract, if the exchange rate of that currency changes at the time of transaction, the purchaser and the seller are not affected. 

There should also be a definite trading strategy that can be very helpful in hedging the currency risks. These strategies should be developed after analyzing the market averages or market indexes properly. On the other hand, there are certain theories regarding the trading process in the currency market. These are also very helpful for currency risk management. All these are specialized things and one may seek professional assistance from the currency risk management firms for the purpose. 

MANAGING CURRENCY RISK WITH DERIVATIVES

Currency risk is managed with the use of financial derivatives. A derivative is a general term and is nothing but the derivation of one variable from another. Derivatives are financial contracts whose value/price is independent on the behavior of the price of one or more basic underlying assets. These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. These assets can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybeans, cotton, coffee and what you have.

A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.

Currency-based derivatives are used by exporters invoicing receivables in foreign currency, willing to protect their earnings from the foreign currency depreciation by locking the currency conversion rate at a high level. Their use by importers hedging foreign currency payables is effective when the payment currency is expected to appreciate and the importers would like to guarantee a lower conversion rate. Investors in foreign currency denominated securities would like to

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secure strong foreign earnings by obtaining the right to sell foreign currency at a high conversion rate, thus defending their revenue from the foreign currency depreciation. Multinational companies use currency derivatives being engaged in direct investment.

A derivative is a financial instrument that derives or gets it value from some real good or stock. It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date.

The largest appeal of derivatives is that they offer some degree of leverage. Leverage is a financial term that refers to the multiplication that happens when a small amount of money is used to control an item of much larger value. A mortgage is the most common form of leverage. For a small amount of money and taking on the obligation of a mortgage, a person gains control of a property of much larger value than the small amount of money that has exchanged hands.

Derivatives offer the same sort of leverage or multiplication as a mortgage. For a small amount of money, the investor can control a much larger value of company stock then would be possible without use of derivatives. This can work both ways, though. If the investor purchasing the derivative is correct, then more money can be made than if the investment had been made directly into the company itself. However, if the investor is wrong, the losses are multiplied instead.

Types of Derivatives

Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.

Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.

Options: Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given

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price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.

Although options can be written on any underlying, let’s use options on common stock as an example. A call option on a stock gives its holder the right to buy a fixed number of shares at a given price by some future date, while a put option gives its holder the right to sell a fixed number of shares on the same terms. The specified price is called the exercise price. When the holder of an option takes advantage of her right, she is said to exercise the option. The purchase price of an option – the money that changes hands on day one – is called the option premium.Options enable their holders to lever their resources, while at the same time limiting their risk. Suppose Smith believes that the current price of $50 for Upside Inc. stock is too low. Let’s assume that the premium on a call option that confers the right to buy shares at $50 each for six months is $10 per share. Smith can buy call options to purchase 100 shares for $1,000. She will gain from stock price increases as if she had invested in 100 shares, even though she invested an amount equal to the value of 20 shares.

Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency.

• Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

A swap is a contract to exchange cash flows over a specific period. The principal used to compute the flows is the “notional amount.” Suppose you have an adjustable-rate mortgage with principal of $200,000 and current payments of $11,000 per year. If interest rates doubled, your payments would increase dramatically. You could eliminate this risk by refinancing with a fixed-rate mortgage, but the transaction could be expensive. A swap contract, by contrast, would not entail renegotiating the mortgage. You would agree to make payments to a counter party – say a bank – equal to a fixed interest rate applied to $200,000. In exchange, the bank would pay you a floating rate applied to $200,000. With

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this interest-rate swap, you would use the floating-rate payments received from the bank to make your mortgage payments. The only payments you would make out of your own pocket would be the fi xed interest payments to the bank, as if you had a fixed-rate m mortgage. Therefore, a doubling of interest rates would no longer affect your out-of pocket costs. Nor, for that matter, would a halving of interest rates.

POLITICAL RISK ASSESSMENT

The three levels of risk that political risk encompasses:

1. Firm-specific risks

2. Country-specific risks

3. Global-specific risks

Firm-specific risks (micro risks)

Business Risk: The risk that a company will not have adequate cash flow to meet its operating expenses. A company's risk is composed of financial risk, which is linked to debt, and risk, which is often linked to economic climate. If a company is entirely financed by equity, it would pose almost no financial risk, but, it would be susceptible to business risk or changes in the overall economic climate.

A business risk is a circumstance or factor that may have a negative impact on the operation or profitability of a given company. Sometimes referred to as company risk, a business risk can be the result of internal conditions, as well as some external factors that may be evident in the wider business community.

When it comes to outside factors that can create an element of business risk, one of the most predominant risks is that of a change in demand for the goods and services produced by the company. If the change is a positive one, and the demand for the offerings of the company increase, the amount of risk is decreased a great deal. However, if consumer demand for the offerings decreases, either due to loss ofbusiness to competitors or a change in general economic conditions, the amount of risk involved to investors will increase significantly. When a company’s risk factor is considered to be increased due to outside factors that are beyond the control of the company to correct, chances of attracting new investors is severely limited

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Foreign Exchange Risks:

1. The risk of an investment's value changing due to changes in currency exchange rates. 

2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk".

This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. 

Governance Risks:The risk that governments will impose constraints on the activities of private

firms. Arises from the conflicting goals of governments (goal: create value for citizens – state socialism – nationalism – religious views) and firms (goal: create shareholder value – free enterprise - internationalism).

Country-specific risks (macro risk):

This is the risk associated with the political and economic uncertainty of the foreign country in which an investment is made. These risks can include major policy changes, overthrown governments, economic collapses and war. Countries such as the United States and Canada are seen as having very low country-specific risk because of their relatively stable nature. Other countries, such as Russia, are thought to pose a greater risk to investors. The higher the country-specific risk, the greater the compensation investors will require.

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The risk inherent in holding shares, bonds or other securities whose fortunes are closely allied with a particular country. If the country goes into an economic downturn, or its debt is subject to a credit re-rating, or international investor sentiment turns against it, investments may well lose value, even though the underlying fundamentals are unchanged. Generally speaking, sovereign risk, as it is also known, is more of a problem for investors in emerging markets than in developed economies.

Global-specific risks:

o Anti-globalizationo Environmental protectiono Poverty o Terrorism and War

MEASURING OF POLITICAL RISK

Macro level political risk (Country specific approach)

Macro-level political risk looks at non-project specific risks. Macro political risks affect all participants in a given country. A common misconception is that macro-level political risk only looks at country-level political risk; however, the coupling of local, national, and regional political events often means that events at the local level may have follow-on effects for stakeholders on a macro-level. Other types of risk include government currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations and government composition changes. These events pose both portfolio investment and foreign direct investment risks that can change the overall suitability of a destination for investment. Moreover, these events pose risks that can alter the way a foreign government must conduct its affairs as well.

Research has shown that macro-level indicators can be quantified and modeled like other types of risk. For example, Eurasia Group produces a political risk index which incorporates four distinct categories of sub-risk into a calculation of macro-level political stability. This Global Political Risk Index can be found in publications like The Economist. Other companies which offer publications on

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macro-level political risk include Economist Intelligence Unit and The PRS Group, Inc.

Micro level political risk (firm specific approach)

Micro-level political risks are project-specific risks. In addition to the macro political risks, companies have to pay attention to the industry and relative contribution of their firms to the local economy. An examination of these types of political risks might look at how the local political climate in a given region may impact a business endeavor. This type of risk process includes the project-specific government review Committee on Foreign Investment in the United States (CFIUS), the selection of dangerous local partners with political power, and expropriation/nationalization of projects and assets.

To extend the CFIUS example above, imagine a Chinese company wished to purchase a US weapons component producer. A micro-level political risk report might include a full analysis of the CFIUS regulatory climate as it directly relates to project components and structuring, as well as analysis of congressional climate and public opinion in the US toward such a deal. This type of analysis can prove crucial in the decision-making process of a company assessing whether to pursue such a deal. For instance, Dubai Ports World suffered significant public relations damage from its attempt to purchase the US port operations of P&O, which might have been avoided with more clear understanding of the US climate at the time.

Political risk is also relevant for government project decision-making, whereby government initiatives (be they diplomatic or military or other) may be complicated as a result of political risk. Whereas political risk for business may involve understanding the host government and how its actions and attitudes can impact a business initiative, government political risk analysis requires a keen understanding of politics and policy that includes both the client government as well as the host government of the activity.

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MANAGEMENT OF POLITICAL RISK

The political risk management strategy depends on the type of risk and the degree of risk the investment carries as also upon the timing of the steps taken.

There are a couple of measures that can be taken even before an investment is made. The simplest solution is to conduct a little research on the riskiness of a country, either by paying for reports from consultants that specialize in making these assessments or doing a little bit of research yourself, using the many free sources available on the internet (such as the U.S. Department of State's background notes). Then we will have the informed option to not set up operations in countries that are considered to be political risk hot spots. 

While that strategy can be effective for some companies, sometimes the prospect of entering a riskier country is so lucrative that it is worth taking a calculated risk. In those cases, companies can sometimes negotiate terms of compensation with the host country, so that there would be a legal basis for recourse in the event that something happens to disrupt the company's operations. However, the problem with this solution is that the legal system in the host country may not be as developed and foreigners rarely win cases against a host country. Even worse, a revolution could spawn a new government that does not honor the actions of the previous government. 

If you do go ahead and enter a country that is considered at risk, one of the better solutions is to purchase political risk insurance. Multinational companies can go to one of the many organizations that specialize in selling political risk insurance and purchase a policy that would compensate them if an adverse event occurred. Because premium rates depend on the country, the industry, the number of risks insured and other factors, the cost of doing business in one country may vary considerably compared to another. 

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However, be warned: buying political risk insurance does not guarantee that a company will receive compensation immediately after an adverse event. Certain conditions, such as trying other channels for recourse and the degree to which the business was affected, must be met. Ultimately, a company may have to wait months before any compensation is received. 

Insurance Cover:

This kind of political risk insurance is purchased by exporters, lenders, investors, and contractors with inventories, equipment, or other assets located in foreign countries. It protects against confiscation, expropriation, nationalization, and other foreign government actions which would deprive you of your rights of ownership or control of your assets. 

Related political risks that are covered include forced abandonment, selective discrimination, business interruption, and "creeping expropriation" (a series of individual government actions which, taken together, effectively result in expropriation). This political risk insurance can also cover non-transfer of dividends, royalties, or other funds following your sale of an asset or disposal of an investment. 

Political risk insurance is available against a broad spectrum of risks, including non-payment products for financial institutions, expropriation, war and political violence, cancellation of operating licenses, exchange transfer problems, import and export embargoes and non-repossession for global corporations. Covers can be purchased individually or as part of a tailor-made portfolio. Our Political risk insurance specialists can place cover in the private market, or in conjunction with ECAs, MIGA or other multi-laterals.

Political Risk Analysis:

Our political risk audits use proprietary financial analysis software combining country risk information, industry factors, and company-specific data to identify

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and prioritize your political and economic risks, and associated financial exposures. The result is an in-depth review of your vulnerability to political and economic risks, and value-at-risk financial exposures. The audit is especially useful for firms with large overseas operations, either directly or through their suppliers.

Risk response:

Good risk assessment does not eliminate risk but it does provide a fair base for managing it. Once risk has been identified and, if possible, given an estimated probability, the company must decide what to do with it. The actions taken to respond to the risk are aimed at improving the profitability of a foreign investment opportunity. Risk strategy and risk orientation in international operations are very company specific depending on the perception of risk and risk taking behavior of a firm. Variables such as size, experience and management philosophy can be underlying reasons for these differences.

Retention:

The significance of risk retention is that the risk is partially or fully withheld by the company. Risk retention can be made either intentionally or unintentionally. When risk retention is made intentionally, it is called self-insurance and means that the company keeps the risk in their own books. This can for example be achieved by creating a subsidiary as a captive insurance company taking on the risk or by establishing a reserve fund to cover for a potential loss. The motives behind risk retention are often economic. By taking on part of the risk, a company can significantly lower the cost of insurance. This can be compared to people only insuring their cars for third party damages and theft instead of a complete insurance. Risk retention can also take place for more practical reasons when the potential losses are considered to be insignificant or when the cost of insurance cannot be justified by the risk exposure.

Reduction:

Reduction of the political risk can be done in two ways. It can either be by loss prevention, which signifies actions taken in order to reduce the probability of a damage. The second alternative is loss control (also referred to as loss protection), meaning actions taken to minimize or at least reduce the consequences or impact of a political event. A somewhat complicated risk reduction strategy is to determine a

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country exposure limit. This exercise requires estimating probabilities and using mean-variance. The strategy has serious downsides, since it is very hard or even impossible to estimate the probabilities and mean-variances. It is also very difficult to implement and monitor the changes in exposure, probabilities and mean-variances from day to day.

Transfer:

Risk transferring is one of the most popular and effective ways to manage risk. The logic behind risk transfer lies in shifting the risk to an outside entity. It can be defined as the reduction of risk exposure by sharing the risk with a third party. For political risk, the risk transfer can basically be achieved in three ways. The most common way to deal with political risk today is through insurance. There is an increasing market for more speculative risk insurance, which now constitutes a very important tool for the management of political risk. Using that alternative, the physical property is retained but the “financial part” of the risk is transferred. A similar option is to hedge the risk through a bank or other financial institution. The third alternative is to transfer the activity or activity exposed to the risk through different forms of unbundling. The latter signifies contractual arrangements such as joint ventures, franchising and various forms of counter trade, shifting part of the risk to an outside entity.

Letters of credit:

Letter of credit is a frequently used means for an exporter to transfer risk to a financial institution. The principle is that a bank undertakes to guarantee the payment of an importer. The exporter receives payment by presenting proof of fulfillment of his part of the deal to the bank having issued the guarantee. This way the risk that the buyer will not have the means or the possibility to meet his engagements is eliminated, since the claim is on the bank, not on the importer. The exporter only needs to worry about the creditworthiness of the issuing bank and the degree of uncertainty is therefore considerably lower. The main disadvantage with the letters of credit is the high cost, especially for third world countries.

Contractual arrangements:

Mutual risk sharing can be done through joint ventures and collective ownership of risky enterprises. One way to transfer the risk to another party is to join a number

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of others in consortia. This response method is very common for firms in the raw material industries. Basically, the consortium spreads the political risk among the companies in question. The partner companies can either be foreign or local. The reason behind a joint venture or consortium is normally to reduce the risk. In some cases there could also be other reasons such as government requirements and the counterpart’s knowledge or legal qualifications. Another way to transfer political risk is through pooling, which is a method that could also be seen as risk reduction. Risk-pooling can be done as a mutual guarantee, where the pool members engage to cover each other’s losses. Each members risk is thereby transferred to a common pool with more or less diversified risk. Compared to insurance there are several positive aspects with pooling. Pre-payment is not necessary for agreements of mutually sharing each other’s losses. Therefore, less information is required for pooling than for insuring. If the pooling is not done through a third party company, the price of handling the risk should also be less important since the insurance company normally has the objective to make profit out of the business. One of the problems with creating a risk-sharing pool is that the parties have to accept the presumption that they all face the same risk. This could be handled through the terms of the contract, but sometimes an agreement could need a lot of negotiation. An important aspect when using this method is that the pool must be large enough to diversify the risk effectively. If the pool only consists of a few companies, or parties with similar risk exposure, much of the benefit is lost.

Avoidance:

Risk avoidance (also called risk elimination) is according to Ting, probably the most commonly practised risk management strategy. The meaning of this concept is to avoid exposure to personal, property or liability risks by not entering a certain field of business or activity.151 By only doing business with the safest countries the probability of a harmful event will decrease, but unfortunately this strategy eliminates many countries with good trade potential. Risk avoidance can occur pre-entry as well as post entry where the former is the choice to not undertake an investment or deal, while the latter is to divest. Both are techniques used to avert probable expected losses and they are a result of forecasts made either internally or externally. Baker et al points out the fact that there are alternative ways to avoid risk for example by tendering a very high bid, placing conditions on the bid or not bidding on the high risk portions of a bid.153 Risk elimination is a way to decrease a company’s exposure to political risk by not taking a risk at all and the use of it is therefore very dependent on the risk attitude of the decision-makers.

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BIBLIOGRAPHY

1) International Financial Management by V.Sharan

2) International Financial management by P.G APTE,5th Edition

3) http://en.wikipedia.org/wiki/ political risk management

4) http://www.aon.com/risk-services/political-risk.jsp

5) Google

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