There are serious reservations concerning the extension of the ‘hard’
risk management, or portfolio, approach to foreign direct investment3 (Elton and Gruber 1975).
• Portfolio analysis looks backwards rather than forwards: it rests on the availability of detailed information about past behaviour, notably that concerning the level of the risk-free return, the market returns on different assets, and return co-variances. The analysis also assumes stable past behaviour so that there is an unambiguous risk- free return, risk premiums for different markets and betas for differ- ent enterprises. Otherwise each will change according to the time period selected for the estimate.
• The relevant time horizon, reflecting a commitment over a protracted period, although not necessarily the lifetime of the assets, is much longer than for portfolio choice. The commitment of resources for such a long period guarantees a higher level of uncertainty.
The first two reservations, indicating very different time perspectives for financial and physical investment, makes it doubtful whether the approach is appropriate for FDI (Calverley 1985 is one of the few to directly address this question). FDI has a much longer time perspective and requires anticipation of future events which are not simply a re- run of the past. Estimating variance, or any other measure of risk, from past data assumes a stability of the environment which is illegitimate.
In normal times, i.e. periods of stable behaviour, the past can be used to anticipate the future. In abnormal times, i.e. periods of instability, this does not work. The latter are frequent enough to cause enormous problems for investors if they are ignored.
• There is a commitment of a wider range of assets to such invest- ments, including entrepreneurial and technical inputs as well as financial resources, creating very different risk exposures.
A Review of Theory Concerning Risk and the Foreign Investment Decision 21
• FDI involves investment in highly specific assets, usually in large indivisible units. There is a lumpiness about the investment which creates what economists call discontinuities.4
• The segmentation of many markets for physical assets by asym- metric information is ignored. This is linked to the fact that for many assets there is a liquidity risk which reflects the lack of a market for such assets which can be accessed at any time without serious loss.
Together these three reservations have significant implications. It is extremely rare that an enterprise holds facilities which are completely independent of each other, assets which yield no economies of scale and scope.5At the very least for international projects there may be a sharing of promotion costs or of research and development. For a given enterprise, because of the existence of significant world-wide value-adding networks, the returns and risks attached to different assets may be highly correlated; there are serious interdependencies and very considerable co-variance. For a ‘global’ portfolio of physical assets held by a multinational enterprise there is, therefore, no risk which is completely non-systematic. This makes it very difficult to diversify away risk by simply having a large portfolio of different assets.
Inclusion of a new asset may change the whole pattern of returns and risk for existing assets. If different country markets fluctuate indepen- dently of each other, entry into a large number of such markets might create such a portfolio, but this involves exporting as the entry mode rather than FDI.
• The range of events which threaten the value of foreign direct investment is much greater than for normal portfolio investment.
The kind of threat is different from that which affects portfolio choice.
As a result of these reservations, the portfolio approach is only margin- ally relevant to an international investment project. The risk premiums advocated in the capital asset pricing approach are unlikely to be appropriate to such a project.
3
Risk and Risk-generating Events
There are never likely to be enough major capital investment decisions facing a company within a reasonable period of time for it to be proved statistically that decisions taken on the basis of an analysis of the risks are better than those taken without any such analysis.
It should be recognised that the use of risk evaluation in business is in essence an ‘act of faith’.
(Hull 1980: 135) This chapter starts by indicating how necessary it is to bring together the disparate approaches to risk in a genuinely integrated manner which assimilates all risk factors and the different disciplinary approaches to risk.
It defines what risk is and shows the universality of that risk with careful distinctions made between incidence, impact and response. The analysis shows how such risk-generating events might be classified. One method of classification is by the different levels at which risk arises and has to be controlled. The analysis then turns to the response to risk by considering the appetite for risk, or degree of risk aversion, of those confronting risk.
Part of such an analysis is consideration of the nature of risk exposure for organisations and individuals, notably different stakeholder groups. In conclusion, the chapter analyses the connection between risk and return which is considered a positive one by financial theorists but paradoxically has appeared in the empirical data to be negative; successful organisations are able to increase returns and reduce risk simultaneously.
There are six sections in the chapter:
• The first section argues the need to take an integrated approach in dealing with the various risk factors.
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• The second confronts the need to define risk in a preliminary way.
• In the third the focus is on the interaction between incidence, impact and response and on the universality of risk.
• The fourth section makes an introduction to the different types and levels of risk relevant to FDI and to the risk exposure of particular assets.
• The fifth section considers the risk appetite, that is, the degree of risk seeking or risk aversion, which characterises individuals or organisations.
• The final section discusses the relationship between risk and return in a dynamic context, particularly whether there is a trade-off between the two.