Pricing Expropriation Risk

Abstract

M The last forty years have witnessed a tremendous growth in multinational corporations; in innovations in foreign political, economic, and social systems; and in attempts by host countries to obtain greater control over the operations of multinational corporations. This has accentuated the need for developing theoretically justifiable procedures to incorporate the risks resulting from these dynamics in the financial decision-making process of multinational corporations. Foreign investments are exposed to two primary risks which emerge from these dynamics, viz., foreign exchange risk and country risk, in addition to those typically faced by purely domestic investments. If a foreign investment's value changes due to exchange rate innovations, it is considered exposed to foreign exchange risk;1 changes in its value due to other dynamics are attributed to country risk. Country risk (also referred to as environmental or political risk) incorporates factors influencing the stability of the host country's political, economic, and social environment, as well as the host country's governmental actions pertaining to capital repatriation, credit, equity ownership restrictions, legal requirements, tax codes, laws for protection of patents, local personnel and product usage, bureaucratic procedures, etc. Country risk can originate from factors which are exogenous to a country (such as the collapse of external markets for its key exports), or endogenous (e.g., a change in ruling political parties or economic policies), or an interaction of the two. (See Lessard [34] for a discussion of these issues.) Invariably, the response to these factors involves some policy choice on the part of The author would like to thank Michael J. Alderson, S. Kerry Cooper, David A. Dubofsky, Donald R. Lessard, Alan C. Shapiro, Jaye B. Smith, Gary L. Trennepohl, three anonymous reviewers, and the editor for their valuable comments. The usual disclaimer is applicable. A portion of this paper was written while the author was Senior Consultant with the Manufacturers Hanover Trust Company at New York and its completion was facilitated by a fellowship awarded by Texas A&M University's Center for International Business Studies, which is gratefully acknowledged. Earlier drafts of this paper were presented at the Western Finance Association and the Financial Management Association meetings. 1See Adler and Dumas [1, 2], Flood and Lessard [19], Mahajan [35], and references cited therein for literature on foreign exchange risk.