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1
 I.B.O.-6
International Business Finance
Disclaimer/Special Note: These are just the sample of the Answers/Solutions to some of the Questions given in the
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information, data and solution. Student should must read and refer the official study material provided by the university.

Attempt all the questions.

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Q. 1. (a) What is loan syndication? Explain the process of loan syndication.
Ans. Unlike many funding techniques syndicated lending process is financing instruments used to raise financing

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from various international markets. Syndication loan is a complex and advanced structural group of financial

e
institutions. Its basic purpose is to lend money to the borrowers on common terms and conditions. This is achieved

in ks
by commencing invitation for bids from borrowers and this process is known as Syndication process. These bids are

l
generally invited on a fully underwritten basis from Euro banks by the sophisticated borrowers.

n oo
With the use of syndicated loan in national markets, Euro market is still considered to be the biggest source of

O b
such credits. This characteristically involves a group of experienced and capitalized banks that agrees primarily to

r -
offer loan to a much broader range of smaller banks.

o E
Loan syndication also offers the borrowers with assurance about the sum invested and the price of funds, while

f
permitting broader supply. If various banks are capable to the share in small parts of diversified loans, their risks will

b d
be more distributed and they will be willing to make more loans.

n
u a
Since, syndication process initiates invitations to borrowers to submit their bids. Further refined borrowers

H
invite bids from Euro banks by defining important loan parameters including amount, currency preferred, final
maturity, grace period and preferred paying offs.

h e
These bids are submitted on a fully underwritten basis opposed to a best effort basis. Since, fully underwritten
bids assures the bidder's commitment to offer funding inspite of the market ups and down's. On the contrary, bids

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submitted on the best effort basis are not sure of raising their finances from the market as per the market response.
This bid letter is addressed to the borrower and signed by the potential banks spelling out mostly the rules and
regulations on which each bidding bank would be geared up to accept the responsibility as an arranger or lead
manager for the syndication management
Subsequently, the borrower will then carefully examine the bid submitted by each bidder. Each bidder is called
upon individually to discuss the terms and conditions as listed in their bids. However, it is the responsibility of the
borrower not to discuss the terms and conditions of one bank to another. The borrower adheres to strict confidentiality.
The borrower on the basis of many factors and not only the cost factor selects the best possible bid. These factors are

2
examined and scrutinized after reviewing all the significant features that are incorporated in a bid format and are
fundamental in fixing up a syndicated credit arrangement.
(b) What are the various types of international debt instruments? Explain any two of them.
Ans. There are various international financial instruments available in the financial market depending upon the
needs of borrowers. These needs are further diversified on the basis of amounts, the length or period of maturity of
the instrument and the type of currency in which the borrowings are requested. Thus, on such terms and conditions
we can classify the instruments as Promissory Notes, Bonds and Commercial Papers. The choice for deciding the
source of finance will depend on costs, borrowings terms and contract obligatory to the lender. Further these instruments
are classified on the basis of their maturity period as short-term, medium term and long-term debts.
Euro notes are responsible to define as the structure of the debt instrument having short-term maturity periods
between 3 to 9 months. However, this period of borrowing may range for mid-term and long-term periods too. In
such instrument, the borrower is able to borrow for shorter periods and at the short-term interest rates by issuance of

g
such Euro Notes to the investor. And hence, the borrower is able to avail all the remunerations and comfort of having

n
i
dedicated medium to long-term borrowing facility. This Euro Note issuance policy is also known as “Resolving

d
Underwriting Facility” (RUF) and also “Note-issuance Facility” (NIF). This RUF is responsible of permitting the

a
borrower to use the credited amount and then repay and can reuse the same in the same way.

e
Rarely banks can list the notes on their financial books and fund these assents due to the risk of failure of the

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issue. Hence, banks sell such Notes to the investors as short-term. These Euro are issued even below LIBOR by high

e
quality borrowers and are generally denominated in amounts of US $ 100000, $ 500000 or more than that. Hence,

in ks
US dollar is supposed to be the most commonly used currency for denomination.

l
The main reason behind issuance of Euro Notes is to structure debt instrument and place it in the market with

n oo
short-term maturities. For e.g. 3 to 9 months. In such cases, if the short-term market is unable to offer the required
liquidity to the issuer, it becomes the responsibility of the underwriting bank to support the liquidity for the agreed
period of the facility.
O b
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Euro commercial paper is a kind of short-term investment loan issued by a bank in the international money

o
f E
market, denominated in a currency that differs from the corporation's domestic currency. Maturity period for such

d
investments lies between few days to 360 days. However, generally on average basis, the maturity period within 90

b n
days seem to offer good profits. Commercial papers sometimes through intermediary like investments banks prove

u a
to be more reliable and cheaper than any other investment. The most common market for such commercial papers is
US, Canada, UK, Japan and Australia.
H
e
The commercial paper is marketed usually by the issuer or through an investment bank. The issuers require a

h
permanent source of fund. And such fund is required to be cost effective to establish a marketing force in the

T
organization to sell-off the commercial papers directly to the investors. Hence, commercial papers markets are much
larger than any other money market instrument but the secondary trading activity is much smaller for them.
A Euro bonds are international bonds that are denominated in a currency not native to the country where they are
issued. Euro bond market, foreign bond market and domestic bond market form the international bond market.
However, Euro bond market is most common of all. The domestic residents usually issue Euro bonds. The currency
of such Euro bond market is in the domestic currency and they are mainly sold to the domestic residents only.
Euro bond market is a market of over US $ 200 billion per annum in the new capital for financial institutions,
corporations and governments. An issuance of typical Euro bond known as “Syndicate” consists of three overlapping
parts. These parts are : (i) manager, (ii) underwriter, (iii) selling group. Once this syndicate is arranged properly, the

3
bond can be announced with defined features and terms. After declaration of the bonds, the prospectus called "the
Red Herring" is prepared.
Mid-term notes serve as an alternative to short-term investments in commercial paper market and long term
borrowings in bond market. Hence they are termed as MTN or medium-term notes. MTN are usually fixed in nature
and have maturity periods shorter than the Euro bonds or domestic bonds. This investment is generally considered as
temporary investment that can be flexible depending upon the choice of the investor. The main reason behind such
nature of the MTN is due to the fact that they are offered on a continuous basis in smaller amounts. This small
amount can be as less than $ 2 to $ 5 million at a time rather than a single large issue.
Under normal MTN plan, an issuer is allowed to raise the funds at “fixed rate” or floating rate or may be at deep
discount paper in any number of currencies. The most important difference of MTN amongst other debt instruments
is that their issuance and maturity are both dependent of the investor and not the issuer. Also, MTN are issued
through the dealers at the time; in the amount and for the maturity as per the investor's requirement.

g
Whereas floating rate notes (FRN) are those instruments whose rate of interest varies with prevailing market

n
i
rates. This term stands for intermediate to long-term security whose rate of interest is pegged to a short- term rate and

d
then adjusted accordingly. FRN are issued outside the country of the denominating currency. They are issued in the

a
form of Euro bonds. Thus they are also referred as capital market instrument. The pricing framework of such instrument

e
defines its character.

R
FRN are generally priced partially as money market instrument having maturity period less than a year and

e
partially as conventional field rate bonds having maturity period more than a year. And FRN generally pays a rate of

in ks
interest that is tied to changes in the short-term periods. Mostly FRN’s are characterised by some features like the

l
reference rate, the margin, the reference rate period, frequency of re-set, coupon payment frequency and maturity

n oo
period.
Q. 2. (a) Why do central banks intervene in the foreign exchange market? What are the consequences of
their intervention?
O b
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Ans. The central bank in India is the Reserve Bank of India, more commonly known as “RBI”. One of the

o
f E
responsibilities of RBI is to control the supply, or the amount, of currency in a country. The most obvious way to

d
increase the supply of money is to simply print more currency, though there are much more sophisticated ways of

b n
changing the money supply. If RBI prints more currency, the money supply will increase. When the government

u a
increases the money supply, it is likely some of this new money will make its way to the foreign exchange market, so

H
the supply of Rupees will increase there as well.

e
A Central Bank will often directly increase the supply of money on the foreign exchange markets. Central banks

h
like RBI keep a supply of most (if not all) currencies in reserve and will often use them to influence the exchange

T
rate. If RBI decides that the Rupee has appreciated in value too much relative to the U.S. dollar, it will sell some of
the Rupee it has in reserve and buy U.S. dollar. This will increase the supply of Rupee on the foreign exchange
market, and decrease the supply of U.S. Dollar, causing depreciation in the value of the Rupee relative to the Dollar.
These are the organizations that will increase the supply of currency on the exchange market. Now we'll investigate
the demand side of foreign exchange markets. Not surprisingly pretty much the same organizations that caused
supply changes will cause demand changes. They are as follows:
1. Import Companies: A U.S. retailer specializing in Chinese merchandise will often have to pay for that
merchandise in Chinese Yuan. So if the popularity of Chinese goods goes up in other countries the demand for
Chinese Yuan will go up as retailers purchase Yuan to make purchases from Chinese wholesalers and manufacturers.

4
 2. Foreign Investors: As before a German automobile manufacturer wants to build a new plant in India. To purchase
the land, hire construction workers, etc., the firm will need Indian rupee. So the demand for Rupee will rise.
3. Speculators: If an investor feels that the price of Mexican pesos will rise in the future, she will demand more
Pesos today. This increased demand leads to an increased price for Pesos.
4. Central Bankers: A central bank might decide that its holdings of a particular currency are too low, so they
decide to buy that currency on the open market. They might also want to have the exchange rate for their currency
decline relative to another currency. So they put their currency on the open market and use it to buy another currency.
So central banks can play a role in the demand for currency.
Supply and demand is often thought of as being two sides of the same coin. Here we see that this is the case, as
in every transaction there is a buyer and a seller, or in other words, a demander and a supplier.
(b) Distinguish between translation exposure and transaction exposure.
Ans. Translation exposure relates to the accounting treatment of changes in exchange rates. Statement No. 52 of

g
the financial accounting standards board (FASB) deals with the translation of foreign currency changes on the

n
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balance sheet and income statement. Under these accounting rules, a U.S company must determine a “functional

d
currency” for each of its foreign subsidiaries. If the subsidiary is a stand-alone operation that is integrated within a

a
particular country, the functional currency may be the local currency, otherwise it is the dollar. In case of high

e
inflation situations (over 100 per cent per annum) the functional currency must be available in the currency of

R
dollars, regardless of the conditions given.

e
The functional currency used is important because it determines the translation process. If the local currency is

in ks
used, all assets and liabilities are translated at the current rate of exchange. Moreover, translation gain or losses are

l
not reflected in the income statement but rather are recognized in owner’s equity as a translation adjustment. The

n oo
fact that such adjustments do not affect accounting income is appealing to many companies. If the functional currency
is the dollar, however, this is not the case.

O b
Gains or losses are reflected in the income statement of the parent company, using what is known as the temporal

r -
method. In general, the use of the dollar as the functional currency results in greater fluctuations in accounting

o
f E
income but in smaller fluctuations in balance sheet items, than does the use of the local currency.

d
Transactions exposure involves the gain or loss; that occurs during settling a specific foreign transaction. The

b n
transaction might be the purchase or sale of a product, the lending or borrowing of funds, or some other transaction

u a
involving the acquisition of assets or the assumption of liabilities denominated in a foreign currency. While any

H
transaction will do, the term “transactions exposure” is usually employed in connection with foreign trade, that is,

e
specific imports or exports on open-account credit.

h
To illustrate this further lets take an example. Suppose a British pound receivable of £680 is booked when the

T
exchange rate is £. 60 to the U.S. dollar, payment is not due for two months. In the interim, the pound weakens (more
pound per dollar), and the exchange rate goes to £. 62 per $1. As a result, there is a transaction loss. Before, the
receivable was worth £680 /. 60 = $1,133.33. When payment is received, the firm receives payment worth $680/. 62
= $1,096.77. Thus, we have a transactions loss of $1,133.33 – $1,096.77 = $36.56. If instead the pound were to
strengthen, for example, £. 58 to the dollar, there would be a transaction gain and we would receive payment worth
£680/. 58 = $1,172.41.
It is, generally, not possible to completely eliminate both translation exposure and transaction exposure. In some
cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one
exposure actually creates the other. Since it is, generally, not possible to completely eliminate both transaction and

5
translation exposure, it is always recommend that transaction exposure should be given first priority since it involves
real cash flows. The translation process, on the other hand, has no direct effect on reporting currency cash flows, and
will only have a realizable effect on net investment upon the sale or liquidation of the assets.
Q.3. (a) What is transfer pricing? Explain with example the technique of transfer pricing.
Ans. Transfer pricing is essentially an outcome of globalization. A distinctive part of International taxation, it
has come to mark the legal responses to business’ profit maximizing tendencies. To give a prelude to Transfer
pricing, International taxation is to be understood. This is one specific branch of taxation which taxes the profits
arising from Inbound Investment (i.e. taxation of income earned by a foreign company in a host country) and Outbound
Investment (i.e. taxation of income earned by a domestic country abroad). The purpose of international taxation is to
ensure that the earnings of a company from a foreign company neither go tax free nor are doubly taxed.
To illustrate, let us suppose a premises that an Indian company has a branch in Singapore and that it earns a hefty

g
business income from that branch. Now since the income earned in respect to that branch has been sourced or earned

n
from Singapore the natural tendency of Singapore government will be to impose a tax on that portion of income of

i
the Indian company which is attributable to business in Singapore. This levy by Singapore is called as ‘Source
Taxation’ for it seeks to levy tax only on the portion of income which is sourced from/in Singapore.

a d
Now once the income has been subject to tax in Singapore, it comes in the hands of the Indian company in India

Re
as the profits earned by its branch are technically and legally a part of the profits earned by the Indian company.
Since the Indian company is legally and factually situated in India, the Government of India will be inclined to tax

e
the profits of the Indian company fully and exclusively (this is called the ‘Residence Taxation’ principle wherein the

in ks
country in which the company or individual is resident applies tax on all income earned by the company/individual).

l
This would lead to a double taxation in the hands of the company in so much of the profits earned in one country

n oo
are being subjected to taxation in two countries. In order to mitigate this wasteful costs (because ultimately taxes are

O b
costs of doing business), countries are obliged to enter into double taxation avoidance agreements (DTAAs, also

r -
called DTCs or Double Tax Conventions) wherein under one of the countries forgoes its right to tax and therefore

o E
tax is effectively levied only in one jurisdiction, which would be determined under the DTAA.

f
Now why this leads to transfer pricing is obvious. Under the DTAA, generally one only country can tax. However

b d
what is not determined here is the rate at which the country would tax. Therefore, despite the DTAA, countries

u a n
remain free to charge the rate of tax which they generally would be charging in other than international tax situations.

H
For illustration, the rate of tax in India is higher than that imposed under UAE. Here, since the objective of the
business is to reduce the costs (and tax being a cost to the business), the transactions sought to be done between the

h e
two would sought to be done in a manner which brings out the minimum possible tax implication thereon. It is in this
context that Transfer Pricing gains solid ground.

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(b) ‘Financial appraisal is the key most appraisal of any project’, Explain and also discuss its relationship
with other appraisals namely technical, market, economic and social.
Ans. Financial analysis assumed an increasingly important role as a scientific tool for appraising the real worth
of an enterprise, its performance during a period of time and its pitfalls. This strategy helps in drawing out the
complications of what is contained in the financial statements. Financial analysis is defined as the process of discovering
economic facts about an enterprise and/or a project on the basis of an interpretation of financial data. Financial analysis also
seeks to look at the capital cost, operations cost and operating revenue. The analysis decisively establishers a
relationship between the various factors of a project and helps in maneuvering the project’s activities.

6
 It also serves as a common measure of value for obtaining a clear-cut understanding about the project from the
financial point of view. An analysis of several financial tools provides an important basis for valuing securities and
appraising managerial programmes. Financial analysis is vital in the interpretation of financial statements. It can
provide an insight into two important areas of management-return on investment and soundness of the company's
financial position. David Hawkins observes that the analyst evaluates results against the particular characteristics of
the company and its industry. He seldom expects answers from this process; but he hopes that it should provide him
with clues as to where he should focus his subsequent analysis.
Internal management accounts provide information, which is valuable for the purpose of control. The information
is made available in the form of accounting data, which may be manifested as financial is made accounting statement.
A financial analysis reveals where the company stands with respect to profitability, liquidity, leverage and an efficient
use of its assets. Financial reports provide the framework within which business planning takes place. They are the
key through which an effective control of a business enterprise is exercised. It is the process of determining the

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significant financial characteristics of a firm. It may be external or internal. The external analysis is performed by

n
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creditors, stockholders and investment analysis. The internal analysis is performed by various departments of a firm.

d
Financial analysis primarily deals with the interpretation of the data incorporated in the Performa financial

a
statements of a project and the presentation of the data in a form in which it can be utilized for a comparative

e
appraisal of the projects. It is, in effect, concerned with the development of the financial profile of the project.

R
Economic appraisal and financial appraisal are effective tools that have application at every stage of Total Asset

e
Management. They can be used for assessing the integrity of capital investment decisions and the effective and

in ks
efficient management of existing physical assets. Application of those tools ensures that the ‘best value for money’

l
is achieved and that scarce resources are allocated in a manner that reflects the Government’s priorities.

n oo
Financial appraisal reviews the purely financial aspects of a product or project;
Economic appraisal reviews the financial and other factors that affect the economic aspects of a product or
project;
O b
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Areas where economic appraisal and financial appraisal techniques should be used;

o
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Assessment of new or replacement capital expenditure, or major maintenance;

d
Assessment of appropriateness of design, operating or other standards;

b n
Other areas of application such as program evaluation and regulation, proposals and review.

u a
Technical Appraisal: Technical feasibility analysis is the systematic gathering and analysis of the data pertaining

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to the technical inputs required and formation of conclusion there from. The availability of the raw materials, power,

e
sanitary and sewerage services, transportation facility, skilled man power, engineering facilities, maintenance, local

h
people etc. are coming under technical analysis. This feasibility analysis is very important since its significance lies

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in planning the exercises, documentation process, and risk minimization process and to get approval.
Socio-Economic Appraisal: How far the project contributes to the development of the sector; industrial
development, social development, maximizing the growth of employment, etc. are kept in view while evaluating the
economic feasibility of the project.
Environmental Appraisal: Environmental appraisal concerns with the impact of environment on the project.
The factors include the water, air, land, sound, geographical location etc.
Market/commercial Appraisal: In the commercial appraisal many factors are coming. The scope of the project
in market or the beneficiaries, customer friendly process and preferences, future demand of the supply, effectiveness
of the selling arrangement, latest information availability an all areas, government control measures, etc. The appraisal

7
involves the assessment of the current market scenario, which enables the project to get adequate demand. Estimation,
distribution and advertisement scenario also to be here considered into.
Hence, the financial analysis is a unique technique as compared to other project appraisals and is useful in the
sphere of financial control, planning and review of review of financial condition of the business organization. With
the help of financial tools the entrepreneur can rationalize his decisions and reach the business goal easily. The
objective of financial analysis is to develop the project from the financial angle and to identify financial characteristics.
It is a tool in judging the performance of a project/enterprise. It helps the entrepreneur, banker and other concerned
people to know about the health of an enterprise. It also indicates the direction in which it is progressing. It also gives
the warning signals, if any, in its own way.
Q. 4. (a) Discuss the various types of risk in project export.
Ans. In executing a project export, the exporter is exposed to various attendant risks like commercial risks,
country risks and exchange and interest rate risks. The riskier the transaction, the harder and more costly it will be to

g
finance. The political and economic stability of the buyer’s country can also be an issue. To provide financing for

n
i
either accounts receivable or the production or purchase of the product for sale, the lender may require the most

d
secure methods of payment, a letter of credit (possibly confirmed), or export credit insurance or guarantee

a
Indian entrepreneurs while investing abroad may face various commercial and political risks. The commercial

e
risks may arise due to insolvency of the buyer; failure of the buyer to make the payment due within the specified

R
period; or buyer's failure to accept the goods, subject to the given conditions. While, the political risks may be due to

e
imposition of restrictions by the Government of the buyer's country or any Government action which may block or

in ks
delay the transfer of payment made by the buyer; war, civil war, revolution or civil disturbances in the buyer’s

l
country. Other unforeseen incidents like new import restrictions or cancellation of a valid import license in the

n oo
buyer’s country; interruption or diversion of voyage outside India resulting in payment of additional freight or
insurance charges which cannot be recovered from the buyer; and any other cause of loss occurring outside India not
normally insured by general insurer.
O b
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The commercial risk arises from the inability of the project buyer to make payment even after full and satisfactory

o
f E
completion of contract. The risk is linked to the creditworthiness of the buyer and the source of funding for the

d
contract. Large value contracts in developing countries are normally funded by Official Developing Agencies like

b n
World Bank; etc. It is quite common in project exports to extend commercial credit for medium to long-terms.

u a
The exporter should have the creditworthiness of the buyer established before allowing credit terms for exports.

H
Banks with the assistance of their foreign offices as well as correspondent banks can get trade/credit information

e
required by the exporter. To ensure the payments of supplies made exporter can resort to irrevocable letter of credit

h
or bank guarantee. Most developing countries in Asia have, in the past, lacked clearly defined policies for the role of

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private infrastructure projects, particularly in politically sensitive fields like energy generation. However, as a matter
of necessity, there is evidence of a general move in these countries towards establishing appropriate structures for
investment in privately financed infrastructure projects.
(b) What are the various types of guarantee/ bonds is the international trade? How do they benefit the
importer?
Ans. The customer shall have legally civil competence, civil behavior and civil obligation in accordance with
laws and the customer shall have legal security for the guaranty in line with requirements of the bank. Guarantee is
an important part of international trade. It gives a buyer certainty over receiving pre-agreed payments if a supplier
fails to meet his contractual obligations.

8
 If an exporter fails to complete a contract on time or according to specification, the importer will suffer various
losses as a result. Seeking compensation directly from the exporter could be a lengthy and costly exercise with an
uncertain outcome. To avoid such losses the importer, as a condition of the contract, could require the exporter to
provide a bond or guarantee for an agreed amount through an acceptable bank or other financial institution. If a
problem occurs the importer would simply demand that the guaranteed amount be paid immediately.
A guarantee is a written instrument issued to an overseas buyer by a bank or financial institution (acceptable
third party) guaranteeing that the exporter or contractor will comply with his obligations under the contract. If he
fails to do so, the overseas buyer will be indemnified for a specific amount. These guarantees, issued by banks or
financial institutions, are provided only on the basis that there is full recourse to the exporter in the event of the bond
being called. The issuer or financial institutions will therefore require a counter indemnity/guarantee from the exporter
that he will be able to fulfil his obligations.
Retention Bond: where a contract calls for, say, 10% of each payment to be withheld until the project is

g
completed and accepted, a guarantee may be issued which enables the contractor to receive the full amount while

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i
assuring the buyer that the issuing bank will refund the retention percentage if necessary.

d
Performance Bond: Given in support of a client’s obligation to fulfill a contractual commitment. It is normally

a
issued before the cancellation of a tender guarantee. It covers non-completion or faulty completion of the contract.

e
Q. 5. . Discuss the various strategies to manage the political risk.

R
Ans. Political risk takes various forms, from changes in tax regulations to exchange controls, from imposing

e
conditions on local production to expropriation, from adopting measures to discriminate in favour of domestic

in ks
companies against multinational companies (Swadeshi Morcha for example). The governments may restrict the

l
access of foreign controlled companies to local borrowings.

n oo
All these policies adopted by governments of various countries lead to the change in the value of an investment,
making it less attractive than before. It may adversely affect the cash flow position of the foreign-controlled companies.

O b
This is a general definition of the political risk, where the value of a foreign investment or its cash position is

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affected because of the policies and actions of local governments. This effect can be positive or adverse.

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Though the political risk may affect the multinational companies, most companies undertake foreign investment

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without detailed planning for or systematic analysis of risk. Thus, a formal assessment of political risk is required to

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be undertaken by the companies intending to invest in other countries. This involves the following steps:

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(a) The recognition of political risk and its likely consequence; this stage is concerned with measuring political
risk.
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(b) 'The development of policies to cope with political risk; this stage is concerned with managing political risk.

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(c) Should expropriation occur, the development of tactics to maximize compensation; this stage is concerned

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with developing post expropriation policies.
Rummel and Heenan identify at least five major approaches which are employed to assess political risk. The
first is the grand tour approach wherein a company engages in some preliminary market research towards a country
by dispatching an executive or a team on an in-country inspection tour. Once the tour was completed, the team meets
with the top management and discusses the potential strengths and weaknesses of the proposed investment.
The second is a hands-on approach in which the company places great trust in the recommendations made by
academicians, diplomats, business representatives and other outsiders who have knowledge about the target country.
The third approach uses the Delphi techniques. The potential investing firm initially lists selective dements
which might influence a nation’s political future, such as the size and composition of the armed forces or the history

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of leadership succession. The firm then asks a number of outside experts to rank the importance of these factors for
the country under consideration. The data may then be aggregated and the country ranked on a high moderate or low
risk basis.
The fourth method uses quantitative methods, somewhat akin to econometric forecasting of economic events.
Multivariate analysis is used to predict political trends based on current and historical information. It analyses the
relationship among underlying political, economic, sociological and cultural relationships.
The fifth approach combines both the subjective and objective approaches and provides a systematic framework
for both the qualitative and quantitative interpretation of data.
Management of Political Risk: Having analyzed the political environment of a country and having assessed
the risk to its operations, a firm should decide
(a) Whether to invest is that country.
(b) If so, how to device coping strategies to minimize the risk.

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Pre-investment Planning: An MNC can follow each or all of the following policies:

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(1) Avoidance

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(2) Insurance

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(3) Negotiating the environment

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(4) Structuring the investment.
(1) Avoidance: Many firms tackle the political risk by avoiding investing in that country. The issue is what

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amount of risk, the company finds acceptable and is prepared to bear. If the firms avoid investing in a high risk

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country, it also foregoes the high returns possibly available on its investment. Thus most multinationals use avoidance

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strategy only rarely and try to recognize and assess the risk, e.g. investing in dictatorial China, or economically

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volatile South Asian countries is risky. However, if the risk does not materialize, the returns are considerable.

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(2) Insurance: Most developed countries sell political risk insurance to cover foreign assets of domestic

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companies. Many multinational corporations take advantage of it.

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Mostly high-risk multinationals will seek insurance. Hence adverse incentives are built in by adjusting premiums

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in accordance with the perceived risks. Screening out certain high risk applicants and by providing reduced premium

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to the companies engaged in activities that are likely to reduce exproprinlion risk.

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(3) Negotiating the Environment: There are two fundamental problems with relying on insurance as a protection

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from political risk. First, there is an asymmetry involved. If an investment proves unprofitable, it is unlikely to be

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expropriated. Since business risk is not covered, any losses must be borne by the firm itself. On the other hand, if the

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investment proves successful and is expropriated, the firm is compensated only for the value its assets. Thus, although

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insurance can provide partial protection from political risk, it is not a comprehensive solution.

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At times firms try to reach an understanding with the host government before undertaking an investment. This is

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called a "concession agreement" in which rights and responsibilities of both parties are defined. These concession
agreements are negotiated by multinational firms with developing countries. However, as the experience in developing
countries shows, such concession agreements are difficult to implement, particularly in countries like Iraq, Iran, etc.
(4) Structuring the Investment: Multinational firms try to increase the cost of interference by the host country
to minimize its exposure to political risk. This can be done by keeping the local affiliate dependent on sister companies
for markets and supplies.
Another strategy is to establish a single global trademark that cannot be legally duplicated by a government.
Control of transportation is user by some companies to prevent any adverse action on their projects by the lost
government.

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