between the risk exposures and tolerances of different stakeholders – in other words, whose risk tolerance is the critical one. It does not con- sider in any depth what assets are at risk and how this might affect the measurement. Quite rightly, it sees these issues as separate from the main analysis, although they should all be part of a proper in-depth assessment of project risk.
There are a number of significant problems which need to be addressed after the identification and classification of the different types of risk and before it is possible to indicate how the evaluation of an investment project might proceed. The first is to ask the relation- ship between a generic measure of country risk and a measure of project risk. The first applies to any investment in a particular country.
The second is highly specific. In the latter case it is reasonable to ask how far it is possible, and even desirable, to move beyond an in-depth qualitative assessment of a particular project, in which there are ele- ments which need to be considered separately and then weighed against each other. There is no doubt that this assessment is time con- suming and expensive. It cannot be repeated frequently. Given the complexity of the risk environments described above, it is likely to demand the full-time activity of a group of specialists over a period of months rather than weeks. This leaves unanswered the problem of review of a project after its implementation or of monitoring the risk level to which that project is exposed in later years. The key issue is how far the assessment needs to be up-dated in the later monitoring of projects which have already been approved. Can the generic risk measure be used for such a monitoring purpose?
It is also interesting how far the assessment is useful in the assess- ment of other projects. There are advantages in pooling such know- ledge and in extending an expertise in this area. Since it is necessary to compare the relevant project, both with other projects and to assess the changing standing of the project as circumstances change over time, it is clearly preferable both to quantify and to reduce the assess- ment to a single measure which makes risk a comparative indicator, one which can be included neatly in any investment project evalua- tion. The emphasis is on comparison, so the assessments need to be carried out consistently.
A second associated problem is that this need for quantification requires the analyst to find proxies which provide a quantitative measure of all the relevant components and sub-components, which often of their nature have qualitative characteristics. It is better to apply this at the level of sub-components or sub-sub-components, the
more specific they are the better. Once quantification is achieved at the lowest level the estimates can be aggregated to yield quantification at the higher levels. This may require the use of more formal tech- niques to identify relevant proxies, such as multivariate regression analysis. Such analysis considers a number of such proxies simultane- ously, indicating which proxies are better at explaining the pattern of FDI flows. This analysis does not offer the final word since it is some- what circular in its reasoning. The modelling is itself difficult. Eco- nomic risk lends itself most easily to this approach since it offers a large number of such quantitative indicators. Difficulties arise for political risk which is least amenable to quantitative analysis. The sim- plest technique is to use the Delphi method in which a group of experts on the political environment is asked to indicate the level of a particular component of risk on a scale which allows them to convert qualitative statements into quantitative ones, such as the Likert scale.
The third problem is to tackle the issue of weighting and how such weights might be estimated. Such weights can be common for the generic measures of different countries but may still change over time as the perception of risk itself changes. It is better to try to maintain a consistent set of weights for as long as possible. However, they will differ from enterprise to enterprise, and from project to project. The advantage of retaining a separation of the different elements is that it highlights the nature of any trade off which must be made; increasing risk in one area may diminish it in another. At all levels in the analysis there is a need for such weighting.
Regression analysis can give a clear indication of the relative significance of individual elements. However, the significance almost certainly changes over time and often in unexpected ways. It might be possible at the aggregate level to use multivariate regression analysis to derive weights which can be attached to different determinants of FDI, including country risk. By re-jigging according to a changing overall index, a best fit could be achieved, but the accuracy of the weightings depends on the specification of the other determinants. An alternative is to use survey information if it is available, that is information on how the decision makers themselves rate the importance of different elements. However, this raises the question – how do you recognise an optimum? Do managers make correct decisions on weighting? Does the market do this implicitly in a way which can be used to estimate weightings?
There are a number of different approaches to the quantification of risk. One is to use past data on the flows of FDI to test the predictive Enterprise and Project Risk 185
ability of any index of country risk. The whole process would involve a sophisticated and time-consuming process of iteration, improving in a qualitative manner the country risk index by re-jigging the weights at different levels and continuously testing and retesting the new index against actual flows of FDI. This is a lengthy process. Its major weak- ness is that it assumes that decision makers operate with a rational view about the choices they face, and that implicit in the actual flows is accurate information about the risk level. There is no reason why this should be so.
As the analysis above has shown, it is difficult to come up with a full quantification of the different types of risk. Having achieved such a quantification, it is difficult to weight the different types of risk and to adjust accordingly the values that go into the present value formula.
Ideally, it is desirable to reduce everything to one formula, that is, to adjust the values put into the present value formula according to the level of risk. It is better to separate the two problems: the measure of country risk or project risk and the incorporation of that measure into the present value formula. The first task is difficult enough without fusing it with the even more difficult task of valuing a project.
An alternative approach is to have a different quantification for returns and for risk and to allow the managers to make a choice based on the trade-off between the two, according to their risk tolerance.
After all, whatever method is used, there is an implicit trade-off, or in the case of the real options approach the establishment of an equiva- lence between a risk-free outcome and a risky one. In the end, this is what probably happens, but it is helpful to provide as much explicit information as possible.