“International Finance and Payments” Lecture V “Risks of International Capital” Lect. Cristian PĂUN Email: [email protected] [email protected]@ase.ro URL:

“International Finance and Payments”

Lecture V

“Risks of International Capital”

Lect. Cristian PĂUNLect. Cristian PĂUN

Email: Email: [email protected]

URL: http://www.finint.ase.roURL: http://www.finint.ase.ro

Academy of Economic Studies

Faculty of International Business and Economics

Course 5: Risks of International Financing

2

Certainty, risk and uncertain situations

Uncertain situations

Risk

Certain

Managers know all the events that could affect their decisions and they

can evaluate the impact on the results

Managers have no any information about

future events that can affect their

decisions and they can’t appreciate the impact on the results


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Identified risks / Assumed risks

Identified risks

Not identified

risks

Risks involuntary

not assumed

Risks voluntary

not assumed

Risks voluntary assumed


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Risks in international business

Environment risks(macro - risks)

RM

Project risks (micro-risks)

Company risks (micro-risks)

RF

RP

No control on further events

Imperfect information

Limited time for decisions

Sources of risks in international

business


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I. Country risk

• it is a new concept introduced by Milton Friedman in 1975 when Citibank grant a credit to a foreign government;

• it was initially connected with the capacity of a government to repay a loan

• today we use this concept in different decisions related to international business:

• international finance (private and public debt)

• FDI’s

• portfolio investments (bond valuation, stock valuation)

• cash flows projections – discounted rate

• we make now a distinction between country risk assessment in case of international financing and international investment


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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

default;• renegotiations of debt or interest.


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Country risk profiles - EEC

CountryRating (S&P)

Rating (Moody)

SpreadCost of Debt

Bulgaria BB B1 4.50% 9.50%Croatia BBB- Baa3 1.40% 6.40%Czech Republic A- A1 0.80% 5.80%Hungary A- A1 0.80% 5.80%Poland BBB+ A2 0.90% 5.90%Romania B+ B1 4.50% 9.50%Russia BB- Ba3 4.00% 9.00%Slovak Republic BBB- A3 0.95% 5.95%Slovenia A Aa3 0.60% 5.60%Ukraine B B2 5.50% 10.50%

Source: S&P, Moody's


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Country risk assessment

1. Selecting group of countries;

2. Selecting the set of indicators (qualitative and quantitative)

3. Grouping indicators;

4. Weighting indicators

5. Selecting the source of information

6. Collecting data

7. Establishing the checking lists

8. According marks and points

9. Calculate the country risk indicator

10. Country risk maps

11. Using country risk in your decisions


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Different risk models

Micro - models

Macro - models

Large number of countries

Small number of countries

Delphi models (BERI; PRS)

Econometric models

Financial models (Euromoney)

Banking models

In House Models(DOW CHEMICAL)


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“Institutional Investor” Country Risk Model

Products: ratings for credit risk;

Information: qualitative indicators;

Source of information: information provided by international banks;

Indicators: economic environment (10p), external debt service (10p),

international reserves / current account balance (10p), fiscal policy (10p),

political environment, capital market accessibility (10p), commercial

balance (10p), international portfolio investment (10p), FDI’s (10p);

Significance: credit risk measured on a scale between 0 and 90.

Methodology: scalar indicator calculated as total amount of points

mentioned above for each country


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“Standard & Poor’s” Country Risk Model

Products: sovereign risk, international bond rating (public or private

Information: qualitative and quantitative information;

Source of information: published source, internal source;

Indicators (sovereign risk):

- political environment (stability, government changing, political system

flexibility, political support, political parties orientation)

- social environment (life standard, income distribution, labor

conditions, relations with neighbor countries, social conflicts)

- economic environment (international investment position, GDP,

exports, economic structure, natural resources, currency regimes,

taxation level;

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

Comercial Expenditures 340000 320000 310000Administrative expenditures 50000 50000 50000

Financial Expenditures 45000 45000 45000Amortization 40000 60000 80000

Cash Flow 955000 725000 995000Taxes 238750 181250 248750

Net Cash Flow 756250 603750 826250


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Exchange risk management

A. Contractual measures:

• simple currency clause;

• simple currencies basket clause;

• weighted currencies basket clause;

• netting

B. Non – contractual measures:

• Parallel loans;

• “Back to back” loans;

• Swaps;

• Forward;

• Futures;

• Options;

• Insurance Contracts.


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II. Interest rate risk

Interest rate risk = possible loss caused by an unfavorable evolution of the interest rate in case of a international credit.

• This risk affects the debtor and the creditor too;

• Interest risk can affect a credit in which is used a fixed interest rate or a variable one too;

• The assessment is based on specific indicators:

• Loan maturity;

• Loan sensitivity;

• Loan duration.


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Interest rate risk - example

Indicator Credit Euro - bonds

Maturity 3,7 years 3,66 years

Sensitivity 1,09 1,14

Duration - -

- Duration 2,85 years 3 years

- Discounted duration 2,66 years 2,81 years


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Interest rate risk managementA. Contractual measures:

• Non - financial clauses

• “Parri pass” clause (equal treatment for creditors);

• “Cross default” clause;

• “Material adverse change” clause

• Financial clauses

• Conditions on different indicators (net working capital, global financial leverage, long term financial leverage, liquidity, solvability);

B. Non - contractual measures:

• Debt renegotiation;

• Floating rate notes;

• Swap, forward, futures, options;

• Collar, cap, floor (synthetic instruments).


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III. Default risk

Default risk = possible loss caused by the payment incapacity of a debtor;

• It is a risk exclusive for creditors

• The assessment is based on a lot of indicators:

• Liquidity ratios

• Profitability ratios and activity ratios

• Financial leverage ratios

• Return ratios and the Du Pont system

• Shareholders ratios

Documents

“International Finance and Payments” Lecture V “Risks of International Capital” Lect. Cristian PĂUN Email: [email protected] [email protected]@ase.ro URL: