Week 7 - Country Risk

Question 1

What is country risk and why is it important? (2)

Answer 1

• The potentially adverse impact of a country’s governance and economic environment on an MNC’s cash flows
• It helps assess the risk of conducting business in a particular country - affecting investment and financing decisions

Question 2

How is country risk different from normal distribution risks? (2)

Answer 2

• Country risk is more likely to be binary, where a risk either occurs or it doesn’t
• Requires subjective judgement based on knowledge and experience rather than statistical analysis

Question 3

How can country risk analysis be used in business decisions? (3)

Answer 3

• Devise a risk management strategy appropriate for a country
• Screen countries to avoid conducting business in high-risk areas
• Revise investment or financing decisions based on the risk assessment

Question 4

What is the role of sovereign credit ratings in assessing country risk? (2)

Answer 4

• Measures the likelihood of a country defaulting on its debt obligations
• The higher the rating, the lower the perceived risk which influences the yield on the country’s bonds

Question 5

What are the pros of credit ratings? (2)

Answer 5

• Simple and easy to understand
• Allows for cross-country and cross-time comparison

Question 6

What are the cons of credit ratings? (2)

Answer 6

• Over-simplified - many factors are condensed into a grade
• Ratings often converge due to herding behaviour and may not be predictive of future risks

Question 7

What are the techniques used to assess country risk? (4)

Answer 7

• Checklist approach - Rating and weighting macro and micro political and financial factors
• Delphi technique - collecting independent opinions and averaging them
• Quantitative analysis - using regression analysis to assess sensitivity to risk factors
• Inspection visits - visiting the country to meet officials, executive and consumers to clarify uncertainties

Question 8

What does the checklist approach in country risk assessment involve? (3)

Answer 8

• Assigning values and weights to political and financial risk factors
• Multiplying the factor values with their weights and summing them up to derive political and financial risk ratings
• Assigning weights to the overall ratings and summing them up to obtain the country risk rating

Question 9

How can country risk be incorporated into capital budgeting? (2)

Answer 9

• Adjusting the discount rate - the higher the perceived country risk, the higher the discount rate should be applied to the project’s cash flows
• Adjusting estimated cash flows - estimating how cash flows could be affected by specific country risk factors allows the MNC to adjust the project’s NPV probability distribution

Question 10

How does adjusting the discount rate help in incorporating country risk into capital budgeting?

Answer 10

MNC reduces the present value of future cash flows to reflect the increased risk associated with a particular country

Question 11

What is the importance of understanding country risk in project evaluation? (2)

Answer 11

• Helps MNCs assess the potential challenges and uncertainties associated with projects in foreign countries
• Ensures that investment decisions are informed and risk-adjusted