Risk and Foreign Direct Investment - Index of

A Review of Theory Concerning Risk and the Foreign Investment Decision 15
natural disasters such as earthquakes in California or Kobe or hurricanes
in Florida, as well as terrorist attacks such as those of September 11
2001. Such events are rare, but their impact can be devastating. At other
times, there is the build up of small changes, which at some stage grow
to constitute a threshold beyond which there is a run-away effect.
Identification of such events is vital to survival. A precondition for successful
risk control is a realistic awareness of future probabilities. 2 Worst
case scenario generation focuses directly on the threat of such extreme
events. In certain circumstances rather than aiming at reduction of
the ‘average’ risk associated with a given project risk control should be
about the identification of the possibility of ‘lower-tail outcomes’ and
their elimination. The more recently developed ‘value at risk’ approach
recognises this by focusing, as a measure of risk, on the maximum possible
loss at various confidence levels, the latter chosen according to the
degree of risk aversion of the investor (Dowd 1998). For example, it
might consider the maximum loss which occurs with a 95% or a 99%
confidence level. Any greater loss is only likely to occur on average once
in 20 or 100 years.
Problems with the conventional approach
The starting world for financial theory is the following:
• a developed set of efficient markets in which risk is traded, both
along with and in financial instruments separate from the products
and services exchanged in those markets,
• a range of derivatives, or contingent claims, which cover every
contingency confronting decision makers, including those making
investments, and derive their value from some underlying asset.
In the words of Moss (2002; 35), ‘Standard economic models actually
envision a world of complete contingent markets, where any risk – no
matter how small or unusual – can be bought or sold in the marketplace.’
In such a market system, all prices fully reflect risk and there is
no need to account for risk or uncertainty separately. The premiums
attached to prices reflect the level of risk as revealed by the probabilities
in the various markets. An investment decision maker would then
be operating in the equilibrium world of an Arrow or Hirschleifer. The
market for risk may not be as developed as this suggests for a number
of very good reasons (see Moss: chapter 2). The concern is not so much
the faults of the underlying Capital Asset Pricing Model (Roll 1977),