Political Risk in the Currency Markets

Political risk is a factor that can generate uncertainty and can directly or indirectly effect investments on a global basis. The risks can create significant volatility, which needs to be mitigated to some extent to allow an investor to focus on profit potential. By obtaining protection against the possible losses created from political actions, an investor can focus their attention on returns.

Political risk can hinder the ability of a portfolio to perform, but can also have an indirect effect on a portfolio by creating headwinds for lenders, borrowers, and intermediaries. There a number of institutions that can assist in the protection of political risk beyond issuing specific credit risk contracts such as credit default swaps. The most prolific insurers of political risk are the re-insurance companies.

Sectors Susceptible to Political Risk

The sovereign interest rate markets are generally considered the most susceptible to political risk. As seen in the recent European sovereign debt crisis, the whims of governments can generate substantial volatility within the interest rate markets. For example, Italian bond yields, which are relatively liquid, soared last summer to nearly 7% at the peak of the crisis and since nearly halved to 4% at the beginning of 2013. Fear that the Italian government would not ask for assistance from the European Central Bank stoked investor fears which assisted in driving yields higher. This same type of pattern also existed in Spanish and Greek bond yields, which was of function of the disagreements between many EU governments.

Currency markets, which reflect capital market flows, are also very susceptible to political instability. A currency can devalue when a government is in trouble, devaluing all of the assets that are priced in that currency, creating liquidation in values for outside investors. Interest rates and currencies are generally highly correlated which means that political risk can create systemic issues for an investor.

Companies that have mobile asset that are in developing countries are often susceptible to political risks. The effects of a political risk event can be severe with consequences isolated to the loss of the value of the assets, or representing a more integral part of the company’s business. Political risks can also result from actions such as refusal to issue an export license where it was previously available, or cancellation or termination of a valid license that a corporation had already procured.

Emerging Markets

Companies with long-term investments in overseas emerging markets are vulnerable to political risks. The recent issues related to Russia and Ukraine are perfect examples. These risks may occur without warning, and can occur from a number of sources in many different forms. Although governments of emerging markets are not as likely to directly penalize investors on purpose, they generally focus on the short term results which can lead to a devaluation of their asset base.

Issues such as changes in the ruling political party can lead to more stringent policies for foreign direct investors. A focus on domestic issues can lead to and anti-Western sentiments. Changes in the foreign policy of the corporation’s home country towards the host country could result in the loss of an investments value.

There have been historical situations in which a foreign government has purposely nationalized equity investments without remuneration to the investor. New legislation with discriminatory acts against a specific western company or all western companies in the local country can create severe negative ramification to a company. Trade embargoes and sanctions enacted by a government can be detrimental.

Issues for Lenders

The cross-border lending business is often hamstrung in pursuing transactions that are restrictions to country exposure mandated by regulatory agencies or internal bank guidelines. Issues such as the freezing of bank deposits by the host government, the inability to convert local currency into hard currency and inability to transfer funds from the host country following the implementation of host government restrictions, can be detrimental toward an active lending business.

Repayment risks can be faced by lenders is there is outright confiscation of the borrower property or investments by the government. Political violence such as terrorism or civil strife may be the direct and immediate cause of default.

Risk Mitigation

Specific types of political risk can be hedged, in a way that is similar to a credit default swap. For example, a re-insurer might generate a swap in which there is a specific notional payout if an event occurs. In the case where a government collapses or an assets is nationalized the investor looking for a hedge will be protected if an event occurs. These binary events are similar to weather hedges, which protect investor from specific one off incidents.

The cost of this type of hedging makes insurance products a luxury that is geared toward the institutional investor or bank lender, as opposed to the retail investor. Retail investors can hedge their exposure by directly hedging the instruments they are trading as opposed to direct event risk associated with political risk.

Political risk affects many financial products including stocks. Companies that have emerging market or international exposure are subject to domestic and global political risk. Hedging the risk that the US would fall of the fiscal cliff or default on its obligations can help smooth the returns of a portfolio. Investors should understand that political risk can be substantial and should be monitored by investors who are trading a top down portfolio.

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