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Political risk comes from changes in the government or culture of a country and can take many
forms, as described earlier.
Regardless of the category, the question is: What risk is imposed by doing business in another
country? And, as we will see later, the follow-on question is: What can be done to lessen the risk?
Exhibit 7.13 Small Co.’s evaluation of risk for China venture.
Exchange rate risk has been lessened as a result of Chinese government policy. However, even
government policy sometimes must give way to practical reality. Although the exchange rate between
the United States and China was stable for 10 years, the price of engines in comparison with the world
market would vary based on the exchange rates between the United States and other countries.
Exchange rate risk arises from unexpected changes in the exchange rates. It can dramatically change
the effective price of a purchase. Looking at the yuan, the effective price of purchases manufactured in
China rose 20% from 2005 to 2008 just due to the currency exchange rate.
Dealing with risk is typically done in two ways. The first is to increase the required return necessary
to make the investment, and we will discuss that now. The second is to look for other ways to lessen
the risk.
Companies calculate a weighted average cost of capital (WACC) and use this as the discount rate or
hurdle rate when estimating the returns for an investment. When looking at an investment in another
country, they should make an explicit decision to raise the rate of return required to take into account
the risks we discussed earlier. Careful analysis of the proposed country is necessary.
In our example we might use something like Exhibit 7.13.
Our numbers are not the result of any careful study. They are chosen to simply make an example of
what might be found. Ultimately numbers like these are the result of judgment after looking at all
available information. Each of these risks seems small, but the chance of something unforeseen
happening over 10 or 15 years is often much larger than one would estimate. There are ways to
simulate what might happen. In any case, it is always good to ask, “What can go wrong?” The answer
can be surprising.
Risk Minimization
One way to eliminate the exchange rate risk associated with the balance sheet is to borrow all or
almost all of the funds in local currency. If the currency weakens, the value of the assets will decline