“International Finance and Payments” Lecture V “Risks of International Capital” Lect. Cristian PĂUN Lect. Cristian PĂUN Email: Email: cpaun @ase.ro URL: URL: http://www.finint.ase.ro http://www.finint.ase.ro Academy of Economic Studies Faculty of International Business and Economics
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“International Finance and Payments” Lecture V “Risks of International Capital” Lect. Cristian PĂUN Email: [email protected][email protected]@ase.ro URL: .
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• we make now a distinction between country risk assessment in case of international financing and international investment
Course 5: Risks of International Financing
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Country risk – credit or investment risk ?
International Credit International Investment
Indicators Different Different
Methodology Similar Similar
Time horizon 1 - 3 years 1-5 years
Utility Cost of debt Expected return
Risk management Before Before / After
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Role of country risk assessment
- To locate the credit / business (risk map); - To take the decision to be involved on international markets (“go / no go decision”); - To establish the level of your involvement; - To develop strategies for your company (ex. strategies to fight against your competitors); - To adapt your further decision related to an international credit or investment in accordance with the latest evolutions on a foreign market.
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Country risk determinants
Country risk – international credit
Current account balance, external debt, BP deficit, economic structure, economic development, the level of export concentration, the import dependency, the convertibility of national currency, GDP, international reserves, inflation, internal capital accumulation, political stability, corruption, credibility and independence of Central Bank, government orientation etc.Educational level of labor force, wages, internal market dimension, internal competition, infrastructure, country accessibility, market accessibility, interest rate, investment facilities, property and transfer regulations, taxation.
Country risk – international investment
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Different types of country risk
International credits International business
Late paymentsDebt service default; External debt repudiationRenegotiation of external debtRescheduling external debt serviceExternal debt moratorium;Temporary default caused by chronic deficit in BP, budgetary deficit, shortfall in exportation incomes, major disturbances on foreign exchange markets, social and internal/external political disturbances ;
ConfiscationNationalization;Expropriation ;Indigenization;Limitations/restrictions on capital repatriationTotal/partial destruction of foreign investment caused by political and social events (strikes, social riots, military conflicts, elections)Profit losses caused by economic crises, shortfall of internal market, legislative instability, corruption etc.
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Country risk management - investmentsBBefore:BBefore:· - gathering more host country specific information · - avoidance of higher country risk locations· - insurance policies (provided by insurance companies)·- negotiating the environment· - adapting the investment project· - geographical or sectorial diversification of investment portfolioAAfter:AAfter:· - permanent supervision of country risk level;· - adaptation of investments in order to reduce the exposure to risk;· - promoting good relations with local operators and institutions;· - disinvestments; profit maximization; sectorial diversification.
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Country risk management – credits
Before:Before:•floating interest rate instead fixed rate;• interest rate adjusted to country risk by using a risk
premium in accordance with risk profile of the debtor;• imposing a restrictive use of lend funds;•financial consultancy for debtors;• loan maturity adjusted to risk;•credit condition;•credit insurance (ex: export credit insurance);•direct participation to the project financed (ex: E.B.R.D. or
I.M.F. credits);• require a set of measures that must be applied by the
debtor as a condition to obtain the credit (ex: structural credits
•additional collaterals or guaranties. After:After:•debt - by - debt swap;•debt - by - equity swap;• rescheduling debt or interest payments in the case of
Significance: ordinal indicator by risk classes (using letters such as BB-)
Methodology: weighted indicator.
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“Political Risk Services - PRS” Country Risk Model
Products: country risk
Information: qualitative and quantitative information;;
Information: qualitative and quantitative information;
Indicators: economic evolution (6%), political parties (5%), external conflicts (5%), corruption (3%), invimplicarea of the religion in politic (3%), involvement of the army in politic (3%), racial or nationalist tensions (3%), terrorism (3%), civil wars (3%), historical evolution of the external debt (5%), transfer control (5%), expropriations (5%), inflation (5%), country’s financial leverage (5%), international liquidity (5%), current account (8%), FX market (5%).
Significance: scale indicator expressed by a number
Methodology: weighted average indicator using different weights for indicators groups: political (50%), financial (25%) and economical indicators (25%).
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“The Economist” Country Risk Model
Products: country risk
Information: qualitative and qualitative indicators;
Source of information: experts (political indicators), internal sources
published sources (economic indicators);
Indicators: GDP growth, inflation, external debt, exports, neighbor
countries, government, army’s involvement in politics, corruption,
ethnical conflicts, internal conflicts.
Significance: scale indicator
Methodology: weighted indicator using different points: economic (33
p), social (17 p) and politic (50 p).
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II. Currency risk in international finance
Currency riskCurrency risk = possible losses caused by un unfavourable evolution
of exchange rate in case of an international financing denominated in
other currency
Currency risk: Currency risk:
A. Transaction exposure: possible losses in case of a specific
transaction (such as export, import or credit);
B. Translation exposure: possible losses in case of translation for a
subsidiary’s balance sheet in mother company one;
C. Economic exposure: possible losses of cash flow in case of a
company involved on international business
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Transaction exposure
• Very easy to asses this type of particular risk;
• The exposure degree can be measured by the variation of current yield in case of a credit using different estimation for FX rate:
1
0
s
sTR
CY
CYE credit
Example: Credit for 100.000 USD, interest rate of 10% p.y., paid at the end of the year, maturity 4 year, reimbursement yearly in equal payments.
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Translation exposure
• More difficult to asses (than transaction exposure);
• Specific for MNC’s with many subsidiaries that requires periodically a consolidation for the balance sheets of this subsidiaries into mother company one;
• The translation could be made using:
• Current rate method;
• Current / non - current method;
• Monetary method;
• Temporal method (for inventories we use a current exchange rate for translation).
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Translation exposure
Example:
Balance US GER (Euro) UK Jap
Assets 500 700 1000 1500
Fixed Assets 200 300 450 700
Current Assets 300 400 550 800
Liabilities 500 700 1000 1500
Stocks 150 200 350 800
Short Term debt 250 275 300 300
Long Term Debt 100 225 350 400
Historical rate: 1 USD= 2 Euro= 3 Pounds= 4 Yen
Current rate: 1 USD= 3 Euro= 6 Pounds= 8 Yen
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Economic exposure
• It is the most complex form of the currency risk;
• The assessment is based on the profit & loss account of a
company involved on international business;
• The exposure degree is measured by the variance of the cash
flow in case of the exchange rate variance;
• To asses this type of risk you should estimate cash flow using
exchange rate in order to transform the inflows and outflows
denominated in other currencies
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Economic exposure – example
Cash flow calculation An I An II An IIIInflows
Sales from exports 1540000 1670000 1890000Investments 100000
Credits 200000Outflows
Current Expenditures 300000 350000 310000Wages 110000 120000 100000