A:

For multinational companies, political risk refers to the risk that a host country will make political decisions that will prove to have adverse effects on the multinational's profits and/or goals. Adverse political actions can range from very detrimental, such as widespread destruction due to revolution, to those of a more financial nature, such as the creation of laws that prevent the movement of capital.

In general, there are two types of political risk, macro risk and micro risk. Macro risk refers to adverse actions that will affect all foreign firms, such as expropriation or insurrection, whereas micro risk refers to adverse actions that will only affect a certain industrial sector or business, such as corruption and prejudicial actions against companies from foreign countries. All in all, regardless of the type of political risk that a multinational corporation faces, companies usually will end up losing a lot of money if they are unprepared for these adverse situations. For example, after Fidel Castro's government took control of Cuba in 1959, hundreds of millions of dollars worth of American-owned assets and companies were expropriated. Unfortunately, most, if not all, of these American companies had no recourse for getting any of that money back.

So how can multinational companies minimize political risk? There are a couple of measures that can be taken even before an investment is made. The simplest solution is to conduct a little research on the riskiness of a country, either by paying for reports from consultants that specialize in making these assessments or doing a little bit of research yourself, using the many free sources available on the internet (such as the U.S. Department of State's background notes). Then you will have the informed option to not set up operations in countries that are considered to be political risk hot spots.

While that strategy can be effective for some companies, sometimes the prospect of entering a riskier country is so lucrative that it is worth taking a calculated risk. In those cases, companies can sometimes negotiate terms of compensation with the host country, so that there would be a legal basis for recourse in the event that something happens to disrupt the company's operations. However, the problem with this solution is that the legal system in the host country may not be as developed and foreigners rarely win cases against a host country. Even worse, a revolution could spawn a new government that does not honor the actions of the previous government.

If you do go ahead and enter a country that is considered at risk, one of the better solutions is to purchase political risk insurance. Multinational companies can go to one of the many organizations that specialize in selling political risk insurance and purchase a policy that would compensate them if an adverse event occurred. Because premium rates depend on the country, the industry, the number of risks insured and other factors, the cost of doing business in one country may vary considerably compared to another.

However, be warned: buying political risk insurance does not guarantee that a company will receive compensation immediately after an adverse event. Certain conditions, such as trying other channels for recourse and the degree to which the business was affected, must be met. Ultimately, a company may have to wait months before any compensation is received.

To learn more, see Investing Beyond Your Borders and Broadening The Borders Of Your Portfolio

RELATED FAQS
  1. Are all multinational corporations also large cap companies?

    Learn about the differences between multinational corporations and large-cap companies, and discover the most important features ... Read Answer >>
  2. How does adverse selection affect insurance premiums?

    Find out what causes adverse selection in the insurance market and why it drives up premiums for all policyholders. Read Answer >>
  3. What are the major categories of financial risk for a company?

    Examine four major categories of financial risk for a business that represent potential problems that a company may have ... Read Answer >>
  4. What does it mean when a country has little activity in its capital account?

    Know what a country's capital account represents and understand what the implications are if a country has little activity ... Read Answer >>
  5. How risky is it to invest in metals and mining companies with operations in politically ...

    Learn about a number of risk factors such as tax policies and changes in fees that can affect a mining company operating ... Read Answer >>
  6. How can an individual investor get involved in FDIs (foreign direct investments) ...

    Learn about what economists call foreign direct investment, and find out why individual investors may find it difficult to ... Read Answer >>
Related Articles
  1. Managing Wealth

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  2. Markets

    Evaluating Country Risk For International Investing

    Investing overseas begins with determining the risk of the country's investment climate.
  3. Managing Wealth

    Risk and Diversification: Different Types of Risk

    Let's take a look at the two basic types of risk: Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the ...
  4. Markets

    What's a Political Economy?

    Economics and politics are intrinsically linked. An economy is frequently one of the biggest points of contention between different political parties. And a political party’s ideologies will ...
  5. Managing Wealth

    Impact Investing Funds: What are the Risks?

    Impact investing funds can carry risks unique to this asset class, including political risk, currency risk and exit risk.
  6. Markets

    What's a Multinational Corporation?

    A multinational corporation is just that – a corporation that operates in multiple nations, with a home office that coordinates global management. Being a multinational corporation is a complicated ...
  7. Markets

    Evaluating Country Risk When Investing

    The main risks of investing overseas are economic and political.
  8. Managing Wealth

    Common Sense Strategies For Adverse Markets

    Adverse markets require skillful adjustments to reduce risk and find new profit opportunities.
  9. Markets

    How U.S. Firms Benefit When The Dollar Falls

    When the greenback is weak, smart investors will invest in multinational companies to benefit.
  10. Managing Wealth

    Risk Management Framework (RMF): An Overview

    A company must identify the type of risks it is taking, as well as measure, report on, and set systems in place to manage and limit, those risks.
RELATED TERMS
  1. Micro Risk

    A type of political risk that refers to political actions in ...
  2. Macro Risk

    A type of political risk in which political actions in a host ...
  3. Political Risk

    The risk that an investment's returns could suffer as a result ...
  4. Country Risk

    A collection of risks associated with investing in a foreign ...
  5. Multinational Corporation - MNC

    A corporation that has its facilities and other assets in at ...
  6. Above Ground Risk

    Non-quantifiable risks that can adversely affect a project or ...
Hot Definitions
  1. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  2. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  3. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  4. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  5. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
  6. Enterprise Value (EV)

    A measure of a company's value, often used as an alternative to straightforward market capitalization. Enterprise value is ...
Trading Center