Compare and contrast country risk analysis with exchange rate volatility

Investing in a country like South Africa is not the same as investing in United States. This is because each country has a different risk profile. Country risk refers to risk associated with investing in a foreign country .Main examples of country risks include economic risk and political risk. On the other hand, exchange rate risk can be defined as the risk that will affect a company’s returns due to exchange rate volatility or fluctuations. The above risks affects the returns of an individual investing in a foreign country hence must be taken into consideration. It is extremely important for such investors to monitor these types of risks over time and how they can be handled.
It’s important for an investor conducts country risk analysis before deciding to continue conducting business or implement new projects in foreign countries. Under country risk, Economic risk can be defined as a the country’s ability to service its debts .A country that is more capable of servicing its debts also characterized by stable finances as well as a strong economy provides a more reliable investment ground. On the other hand political risk can be defined as any political decisions made in a country that might affect the returns of an investor in such a country. A country with unfriendly political climate is not a choice for any rational foreign investor. Exchange rate volatility represents the degree to which the exchange rates of a country varies over time. Volatile exchange rates, increases the exchange rate risk and makes investment in a foreign country difficult and risky.
Investors monitor their operations closely, in order to assess to what extent they are they are exposed to exchange rate risks and country risks. Therefore financial managers should be aware of how to measure the exposure on their investments to such risks hence determine how to protect their investments. Given the nature of the country risk, measurement of such a risk, can be a difficult endeavor. Analyzing a country’s risk can be done using different tools investors have at their disposal, from sovereign ratings coefficients to betas .There are two approaches to measuring the country risk –the qualitative and the quantitative approach. The quantitative approach, involves use of statistics and various ratios to determine the risk for example, the debt to GDP ratio or the beta coefficient and various indexes used to measure the country risks such as the MSCI index. Investors can access this information through various online sources or publications by rating agencies. On the other hand, qualitative approach uses subjective analysis to determine risks. For example use of political news or political opinions. Various political and various economic factors, are assigned different ratings and these ratings are then consolidated to derive an overall assessment index of the country risk. This information can be obtained from economic publications or international news aggregators among other sources. In contrast, foreign exchange risk can be assessed by measuring exposure to exchange rate fluctuations which can be categorized into three forms namely transaction, economic and translation exposure. Transaction exposure can be assessed using various methods one, the Value-at-Risk Method, which applies volatility and currency correlations which it uses to determine a day’s maximum potential loss on the value of MNCs to exchange rate volatility. Economic exposure can be measured using sensitivity of earnings to exchange rates. Which involves developing a subjective prediction of cost and revenues of a firms income statements by comparing the movements of earning to currency fluctuations. Lastly, translation exposure of a MNCs depends on the factors such as the proportion of its business that is conducted by foreign subsidiaries, location of its foreign subsidiaries as well as the accounting method it uses.
Both Country risk and Foreign exchange volatility can be managed using various approaches. For example MNCs may rely on unique supplies or technology where it can stop supplies if it is treated in any unfair manner. It can as well hide its technology in its production process, borrow local funds in a situation that there is a government takeover, the MNCs not only losses the subsidiaries but also still owes home country creditors. Lastly, MNCs can decide to purchase insurance to cover various risk exploration and other political risks. On the other hand, foreign exchange risk may be hedged or eliminated by: purchasing derivatives such as forwards ,future an options , Invoicing in domestic currency , speeding or slowing payments of currencies expected to appreciate or depreciate respectively as well as speeding or slowing collection of currencies expected to depreciate or appreciate respectively.
In conclusion Country risk and exchange rate volatility are a great challenge to MNCs and foreign investors. Therefore, there is a need for proper analysis and measurement of exposure in order to hedge and mitigate companies’ risk arising from these factors which can lead to low profitability and sometimes adverse losses.

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Carolinemakenamutwiri answered the question on February 16, 2019 at 12:54