risk. There are many attempts to rate directly the country risk level of different economies, notably by rating agencies which specialise in the assessment of country risk. Such country risk indexes as the Euro- money Index are common. Some of these estimates are publicly avail- able and are discussed in chapter 11. The approach adopted in such ratings is critical to any investment appraisal. The present chapter seeks to extend this approach to industry and global risk.
The problems discussed make it appropriate to separate fully the two stages in the incorporation of risk in the valuation of an investment project. The assessment of risk is treated as a separate procedure. The assessment, and quantification, of risk requires the completion of basic steps common to all types of risk:
• identification of the main components of each risk type,
• a breakdown of those components into sub-components, and even sub-subcomponents,
• at each level a weighting of the various elements,
• identification of any co-variance between the components,
• the selection of proxies which make possible a quantification of components,
• collection of the relevant information.
The identification, rigorous definition and weighting of risk components is a necessary preliminary to any attempt to measure either generic or specific risk.
the particular model used to describe a relevant economic system. The other terms are used to describe events of an extreme kind, marked out by the magnitude of their potential impact – physical, financial or psy- chological. It is not difficult to accept a ranking by the magnitude of the relevant impact, running from crisis to disaster to catastrophe. Any particular threshold level chosen is arbitrary.
Global risk is in principle a problem everywhere. It is the perception of a threat, rather than the actual incidence or impact, which extends to the whole world. Some types of global risk affect particular regions or groups of industries, but not all. Shocks occur in particular places, but it is of their nature that they can occur in many places; there is a degree of randomness which characterises their occurrence, often more apparent than real. Perceived global threats reflect patterns of inci- dence of the related shocks. An earthquake, volcanic eruption or tsunami is more likely to occur on fault lines in certain parts of the world. At certain times of the year, Florida is likely to be threatened by hurricanes. Disease has particular epidemiological paths. Even in the case of war, it should be possible to predict where it will occur and how far it will extend. It is helpful to understand the causation of such shocks in order to understand their location.
There seems to have been an increase in the impact of catastrophes or disasters which qualify as global shocks. There is certainly an increased sensitivity to such risk. It is highly likely that the amount of global risk has increased. Whether this apparent increase in incidence is real or simply the result of an increasing impact, which results from more capital being at risk, is unclear. The accumulation of capital in all countries, but notably in developed countries, particularly the infrastructures necessary for modern economic activity, has created a hostage to bad fortune. A breakdown in the infrastructure can have dire effects on the operation of any business, whether it is the breakdown of the transport, communication or energy systems. Such infrastructure is threatened by a host of global shocks.
Global risk can be defined:
• by the locational range of the initial risk-generating event. In some cases, the location is a moving one. The event(s) or relevant behav- ioural change(s) might be located in regions covering more than one country, for example, a geological fault line or even the epidemiolog- ical lines of the spread of disease. Terrorism can occur anywhere, but is more likely to occur in certain parts of the world,
• by the scope of the exposure to particular kinds of shock. For example, some risk-generating events have their source outside the
national jurisdiction in which they have a significant impact. The location of significant impact may be uncertain. There may be a threat to many different regions. In an extreme case, the threat is universal, as with terrorist attacks, an epidemic disease such as AIDS or SARS or a computer virus. There are other types of shock which in certain circumstances become universal, e.g. war or economic depression,
• by the degree of impact on a relevant performance indicator at the highest level, which might be a key demographic indicator, the overall level of profit in a region, the rate of capital formation or even the GDP growth of the affected countries. A global shock might be defined as one which has a sufficiently large impact to make necessary international assistance,
• by the identity and location of the appropriate risk control agency.
The nature of interdependence may make international cooperation not just desirable but critical to the containment of the impact.
Many of these events are infrequent, but have a large impact when they occur. Global risk is the risk, which for various reasons cannot be dealt with at lower levels, but has to be handled by international agencies or with the cooperation of different governments.
The global risk environment comprises an increasing number of dif- ferent sources, events or groups of related behavioural change which qualify as risk-generating. The source of such events differs – some have a natural provenance such as climatic shocks – drought or floods, others are of human making, including war or economic depression (White 1987 and 1992). Of the latter, some relate to the nature of technology, others to the operation of integrated markets, and others to the political aims of governments or other organised groups, including terrorist groups. In some cases, there is a mixture of natural and human causation. Some events generate pure risk such as fire, others have an upside as well as a downside; there may be positive cli- matic fluctuations which increase food production. Volcanic erup- tions create fertile soil for the future. In few cases is it impossible to find some benefit resulting from the shock. Even a fire may clear away old buildings which are inappropriate to the new economy.
Global risk can take many different forms:
• an international depression such as the Great Depression of the 1930s, or even lesser events such as the Asian Economic Crisis of 1997 whose impact was limited largely to developing countries.
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Potentially there are significant contagion or herd effects which cause an initial crisis to spread and to enlarge its impact into a disas- ter or catastrophe:
• war or civil unrest which spills across international frontiers;
• terrorist attacks of various kinds;
• natural catastrophes, some linked to global climatic change, but affecting broad areas of the world such as earthquakes, volcanic eruptions, storms (typhoons, hurricanes or cyclones), floods and tsunamis. Some are less dramatic such as drought. Climatic shocks sometimes accumulate into famine. Human action, it is argued, through global warming has increased the incidence of such climatic shocks although the degree to which this is true is contentious;
• computer viruses;
• disease of various types – epidemics such as AIDS or SARS, epizootics such as foot and mouth and mad cow disease or plant diseases such as phylloxera or rust (smut). These are traditionally of great impor- tance, e.g. outbreaks of plague such as the Black Death, the onset of disease among unprotected populations such as those in the Americas before white settlement or periodic outbreaks of influenza such as the Spanish flu which after World War I killed more people than the war itself.
Any typology of global risk seeks to identify independent components and then the sub-components which comprise these components (see Figure 8.1).
There are three main difficulties associated with exploring the nature and implications of such shocks, using global risk as a model for the other types of risk:
• predicting their incidence
Frequency decreases with the size of impact. Because these shocks are infrequent and the records insufficiently long to test the probability of occurrence, they are difficult to predict. It has become increasingly important, but much more difficult, to be able to predict that frequency, which usually requires a sophisticated understanding of causation. There is considerable effort being invested in improving the predictive capacity of the relevant organisations researching in this area.
• understanding their causation
This is important because it makes possible prediction. There are still arguments about the causation of such prominent events as the Great Depression. Disease mutates and it is unclear why disease sometimes becomes epidemic, even among populations which have an acquired immunity. Forecasting volcanic eruptions is not easy, but there are geological explanations.
• anticipating their impact
This reflects exposure which changes with the nature of the assets at risk, but shocks have a greater impact on the unprepared and those without the resources to combat the shock. It is necessary to identify and value these assets. The build up of infrastructure and of capital investment in developed countries increases the potential exposure, while at the same time their capacity to mitigate such risk has increased.
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Natural events
Social events
Political events
Economic events
Technical events Drought Floods Earthquakes Volcanic eruptions Tsunami
Wars
Depression
Computer Viruses Epidemics or epizootics Global risk
Figure 8.1 A typology of global risk