In the past, there was a global trend for investors to seek out low-risk investment opportunities. However, this has changed in recent years with many investors looking at higher-risk investments as a way of generating more returns on their capital. This is especially true when considering political risk in investment.
Investors are now keenly aware that they must consider not only macroeconomic factors but also country and regional risks such as political instability or potential regime change before deciding which type of investment portfolio to pursue. The reason for this is that most countries have become reliant on foreign capital flows and so any disruption to these can be devastating for the economy and currency.
So let’s find out what are political risks and how to avoid them.
Political risks: Explained
When an investor looks at a company, they will weigh up the risk of doing business with them. This means looking at the value and demand for their product or service as well as issues such as country risk.
Simply put, country risk is how likely investors think it is that political instability could affect the economy and currency of a given market. Therefore, if investors perceive that there is a high likelihood of political instability occurring in a country, they will be much less likely to invest – even if the investment opportunity may be profitable.
As such, investors should avoid regions where they expect significant political unrest or changes in the government as this could put their investments at risk and lead to significant capital losses.
At the same time, investors should understand that political risk is not only limited to actual regime change. For example, in many countries, concerns over a new government’s ability to maintain peace domestically can be enough to deter an investor from putting capital into the economy. Moreover, any changes in government policy that could affect the country’s economy or other investment opportunities could also have a negative effect.
What causes political risks
Many different factors can lead to an increase in political risk. The main one is the election of a new government – either at the federal, regional, or local level.
For instance, after a long period of unquestioned leadership, an election could lead to changes in the government’s policies. Investors will then look at this and consider if they are likely to benefit or be negatively affected by these decisions. If they perceive that there is a good chance of being negatively impacted, they may delay investing until they have more information about how the government will act.
Another key factor that can lead to a rise in political risk is social unrest. This can include things like civil wars, protests against economic reforms, or even widespread violence against particular groups of people within the country. When investors consider this level of risk, they will either wait until it has passed or simply avoid investing in the country as a whole.
Some events may not lead to an increase in political risk but could still pose a problem for investors. This includes things like natural disasters, terrorism, and economic downturns.
How to avoid political risks
So how can investors avoid political risk when investing abroad? The first thing is to identify which countries may be affected by a change in government and which are likely to remain stable. In addition, investors should look at whether or not the country has been prone to political instability in the past and use this to identify and avoid potential trouble areas.
Another solution is to diversify investments as much as possible. For example, an investor could spread their risk by investing in a range of countries or even markets rather than putting all their capital into one place. This reduces risk because if any political risk does lead to a downturn in a particular country, the other investments should be able to balance this out and provide some returns.
Finally, investors can use political risk insurance – also known as a Foreign Exchange (FX) or Currency Swap Guarantee – to protect their currency against potential losses caused by negative changes to foreign exchange rates. This would allow an investor to secure their position as well as guarantee the return on their investment.
Conclusion
Investors should consider political risks when putting their money into a company or country since this can affect the value of their investment. However, they should also look out for changes in government policy and social unrest that could lead to an increase in risk. In addition, investors should identify areas where potential negative effects are likely to be low – such as countries with stable governments – and ensure that they spread their risk by diversifying across multiple markets. Finally, investors can use political risk insurance to protect their investment against negative changes in the exchange rate.
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