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. How many nations must a company trade in to be considered a multinational corporation?

    Learn about the conditions a company has to meet to be considered multinational, and find out when investing in multinational ... Read Answer >>
  2. What is the difference between market risk and country risk?

    Learn about market risk and country risk, some examples of each and the main difference between these two types of risks. Read Answer >>
  3. 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 >>
  4. 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 >>
  5. 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 >>
  6. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
Related Articles
  1. Insights

    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. Managing Wealth

    Evaluating Country Risk For International Investing

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

    Examples of Adverse Selection in the Insurance Industry

    Find out what the term "adverse selection" refers to in the insurance industry, and learn how insurance companies protect themselves from adverse selection.
  4. Financial Advisor

    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.
  5. Personal Finance

    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.
  6. Investing

    Common Sense Strategies For Adverse Markets

    Adverse markets require skillful adjustments to reduce risk and find new profit opportunities.
  7. Managing Wealth

    Why Companies Need Risk Management

    Implementing risk management strategies can save an entire organization from failure. Is yours up to snuff?
  8. Trading

    How U.S. Firms Benefit When The Dollar Falls

    When the greenback is weak, smart investors will invest in multinational companies to benefit.
  9. Insurance

    What is Adverse Selection in the Insurance Industry?

    Adverse selection impacts the markets for health insurance and automobile insurance, but interfering with actuarial work has consequences.
RELATED TERMS
  1. Micro Risk

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

    Coverage that provides financial protection to investors, financial ...
  3. Country Risk

    A collection of risks associated with investing in a foreign ...
  4. Political Risk

    The risk that an investment's returns could suffer as a result ...
  5. Above Ground Risk

    Non-quantifiable risks that can adversely affect a project or ...
  6. Institutional Investor Index

    A measure of sovereign debt risk that is published biannually ...
Hot Definitions
  1. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
  2. Two And Twenty

    A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
  3. Market Capitalization

    The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
  4. Expense Ratio

    A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
  5. Mezzanine Financing

    A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing ...
  6. Long Run

    A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all ...
Trading Center