Abstract
Political risk assessment provides a prediction of the likelihood that future foreign government actions will deteriorate the return on a planned foreign investment. Such political risk predictions are commonly provided with great assurance by political experts. Political risk assessments are frequently quantified to two or three significant figures, so that comparisons can be made between various countries, at various times in the future. It is the contention of this paper that most of such quantifications and predictions are nonsense; that the political future is not being accurately predicted.
It is useful to describe some general axioms on predicting the future: (1) Future events can be predicted in a rigorous manner only if they represent expected outcomes of physical laws; (2) Future events can be predicted with some statistical confidence if they represent a modest extrapolation of consistent history into the future; (3) The farther into the future one predicts, the less reliable history-based predictions should be; (4) Predictions become less certain as more parameters influence the event; (5) Predictions must be less certain as more precision is required; and (6) Predictions of singular future complex political events are merely guesses, no matter how they may be swaddled in statistical mumbo-jumbo.
For proper analysis of political risk it is important to create multiple scenarios of the future, to be well acquainted with foreign politics, and to understand the economic fundamentals of the country where you are considering investments.
Such approaches allow management to look for possible flexibilities in investments, to consider insurance, hedging, and other risk abatement techniques against some of the most likely negative political/economic outcomes. The proper investor question is … "what can I do to mitigate possible future country risk?" … not, "what is the proper discount factor to allow for future country risk?" Wise investors need to take positive actions early in the investment cycle so that they may alter, rather than hope to measure, political risk in foreign investments.
