• Section five explores the nature of industry risk, distinguishing it from other types of risk, and outlines a comprehensive classification of industry risk.
• In the final section there is an analysis of the components of industry risk.
expressing the systematic nature of country risk. It does not assume that liquid markets exist everywhere nor does it assume that markets are efficient where they do exist, certainly not efficient in that they fail to incorporate significant information which is available to the enterprise.
The conventional approach to the incorporation of risk in the appraisal of an investment project also fuses the two stages, those of risk assessment and of project valuation. This analysis adopts a sepa- rate treatment of the sources of risk and focuses on an exploration of the types of risk-generating events, or risk-generating changes of behaviour, which characterise the relevant risk environments. It is appropriate to consider total risk, not just systematic risk for two main reasons:
• the enterprise is a coalition of stakeholders and any project, viewed as stand alone, has a similar network of linked stakeholders, most of whom do not have a diversified portfolio of assets,
• the enterprise is not able, or for good reasons often does not desire, to diversify its assets.
There are two sets of events with which the analysis deals – those which are relatively frequent but which have an impact which is man- ageable and those which are extreme, or lower-tail, events which are infrequent but which have a potentially large impact. Frequent events which occur in a predictable pattern are not a source of risk. In any dis- tribution of probable outcomes those which lie within the accepted confidence level are sometimes regarded as expected and those which lie beyond that confidence level are unexpected. The dividing line between the two is somewhat arbitrary. However, the point is that the usual concentration on the variance or standard deviation of profit or share value as a measure of risk neglects an enormous amount of infor- mation which is directly relevant to the future performance of an investment project.
The ‘expected’ events are capable of being handled through the law of large numbers. Insurance companies usually have no difficulty in dealing with the normal every-day threats to life and property, which can be summarised in mortality tables. They can even deal with par- ticular kinds of country risk. An increasing range of risk-generating events have been drawn within the fold of insurance and defined as expected in that they conform to a normal distribution of outcomes.
The impact of extreme events, especially those which do not fit a The Context of Risk 129
normal distribution, reflects the amount of capital which is at risk as well as the frequency of such shocks.
No matter whether managers engage in actual risk management or not, markets are a good source of relevant information for investment appraisal, provided they are at least weakly efficient (Anderson and van Wincorp 2004). There are three ways in which the market puts a value on risk – firstly through implied risk spreads on international loan instruments, best shown by government loan prices (Merton 1974);
and secondly, through insurance premiums charged by insurance agencies, such as OPIC or AFIC for political risk; and thirdly through the market for derivatives, which has the advantage of looking forward rather than backwards.
The first source, the risk spread, is of limited helpfulness to foreign direct investment since the spread measures sovereign or government risk, that is the creditworthiness of governments, which may bear little relationship to the riskiness of private investment projects.
However, there is a link with country risk through government policy. It gives a first look at the role of government in any FDI deci- sion. The second market source, insurance, is far from comprehensive in its coverage. Since the market for insurance is not perfect, the prices of insurance only give imperfect information on risk. Implicit in the insurance premiums charged is a view about the probability of certain risk-generating events. Again, this is information which is useful. Where well-developed futures markets exist and the source of the risk is price variability, the use of future prices can help, e.g. in appraising the value of an oil field or a gold mine. The existence of such information constitutes a starting point for any quantification.
For most projects, there is no such relevant market. A view on future volatilities can be found if there are developed markets for debt, derivatives and risk contingencies of various kinds. The prices thrown up by such markets are a valuable source of relevant information on future expectations. They offer information on the market view of volatility (Bodie and Merton 1995), that is the riskiness which the market has factored into prices. The prices of futures, options and swaps and their insertion into the Black and Scholes formula allow the extraction of implied volatilities.
Because of the deficiencies of each of these three sources, it is better to assess the relevant risk directly. There is a need to focus on the risk environments relevant to specific investment projects. It is also neces- sary to consider all the sources of risk, not just in order to appraise accurately but also to make possible the mitigation, or reduction, of
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.