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MANAGING RISK IN INTERNATIONAL BUSINESS

The Three Steps to Effective International Risk Management. Identify the individual risksAssess risk magitudes and exposure levelsIncorporate the risk assessment in the decision making process. Political Risk. DefinitionSourcesAssessment techniques. Modern Tools of Financial Decision Making. Required input: MARKET DATAMean-variance analysisContingent claims analysisModigliani-Miller.

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MANAGING RISK IN INTERNATIONAL BUSINESS

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    1. MANAGING RISK IN INTERNATIONAL BUSINESS Techniques and Applications 1) International business risk is a wide ranging concept. Examples: - for the exporter it can mean currency risk on export transactions, or the imposition of tariffs, and quotas; - for the direct investment, merger or an acquisition it can mean losses or reduced profits due to macroeconomic mismanagement, exchange controls, expropriation or other types of government intervention; - for the lender it can mean payment delays and default; - for the portfolio investor it can mean market volatility, currency fluctuations, transaction costs such as brokerage fees, stamp duties, taxation and other regulations. The possibilities are limitless. 2) The international economic and financial consultant should be aware of what the risks are and how they can be assessed and managed. Examples: - in a foreign acquisition, the cost of possible losses due to government intervention or the volatility of cash flows caused by currency fluctuations should be factored into the evaluation process; - legal counseling is most effective when it anticipates potential conflicts and and advises on how they can be avoided or their effects minimized.1) International business risk is a wide ranging concept. Examples: - for the exporter it can mean currency risk on export transactions, or the imposition of tariffs, and quotas; - for the direct investment, merger or an acquisition it can mean losses or reduced profits due to macroeconomic mismanagement, exchange controls, expropriation or other types of government intervention; - for the lender it can mean payment delays and default; - for the portfolio investor it can mean market volatility, currency fluctuations, transaction costs such as brokerage fees, stamp duties, taxation and other regulations. The possibilities are limitless. 2) The international economic and financial consultant should be aware of what the risks are and how they can be assessed and managed. Examples: - in a foreign acquisition, the cost of possible losses due to government intervention or the volatility of cash flows caused by currency fluctuations should be factored into the evaluation process; - legal counseling is most effective when it anticipates potential conflicts and and advises on how they can be avoided or their effects minimized.

    2. The Three Steps to Effective International Risk Management Identify the individual risks Assess risk magitudes and exposure levels Incorporate the risk assessment in the decision making process

    3. Political Risk Definition Sources Assessment techniques

    4. Modern Tools of Financial Decision Making Required input: MARKET DATA Mean-variance analysis Contingent claims analysis Modigliani-Miller

    5. Shortcomings of Traditional Techniques Unsuited to modern financial decision making data parameters applications Generally imprecise and difficult to apply

    6. The New Framework Overcomes These Shortcomings Uses market data (international prices) Generates parameters compatible with modern portfolio and option pricing theory

    7. Generating the Data: Four Steps Establish accounting discipline Define income flows Define expenditure flows Link income and expenditure to the balance sheet

    8. Important New Decision Making Parameters Macroeconomic profits Market value of the economy The economy’s rate of return The economy’s financial risk premium The economy’s systematic risk (beta)

    9. Assessing Country Specific Financial Risk Estimate standard deviation of country rate of return Estimate total amount of foreign debt and its duration Apply the information in the Black-Scholes option pricing formula

    10. New Parameters: Examples The financial risk premium Insolvency or illiquidity The maximum debt level Implied volatility

    11. A Big Question DOES IT WORK?

    12. CLARK vs . EUROMONEY The Forecast 1988 The Clark forecast: Euromoney, September 1988, page 234 60 countries The EUROMONEY forecast: Euromoney, September 1988, page 235 117 countries

    13. CLARK vs. EUROMONEY The Result 1993

    14. Estimating Systematic Risk Construct the World Index Estimate macroeconomic market value for each country Sum the market values of all countries to create the world index Regress country returns against percentage change in world index to estimate Beta

    15. Performance Measurement INTERNATIONAL PORTFOLIOS 1. To answer this question I constructed mean variance optimized ex ante portfolios using the World Index over the period 1982-1991 for three types of assets: - money market instruments - long term government bonds - equity indexes. The universe included 60 countries. 2. I compared the results of the optimized portfolios with the performance of other diversification strategies (equal weights, GDP weights, Japan-Germany-Switzerland)1. To answer this question I constructed mean variance optimized ex ante portfolios using the World Index over the period 1982-1991 for three types of assets: - money market instruments - long term government bonds - equity indexes. The universe included 60 countries. 2. I compared the results of the optimized portfolios with the performance of other diversification strategies (equal weights, GDP weights, Japan-Germany-Switzerland)

    16. Money Market Portfolios 1982-1991

    17. Long Term Government Bond Portfolios 1982-1991

    18. Equity Portfolios 1982-1991

    19. Excess Return to Risk for Selected Portfolios 1982-1991

    20. Outline Brief review of traditional international risk analysis Presentation of new techniques Applications direct investment portfolio investment cross border loans

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