The Management Of Political Risk

The Management Of Political Risk

Erasmo Giambona
University of Amsterdam – Finance Group; Tinbergen Institute – Tinbergen Institute Amsterdam (TIA)

John R. Graham
Duke University; National Bureau of Economic Research (NBER)

Campbell R. Harvey
Duke University – Fuqua School of Business; National Bureau of Economic Research (NBER); Duke Innovation & Entrepreneurship Initiative

July 12, 2016

Duke I&E Research Paper No. 2016-32


We explore a long standing prediction in the international business literature that managers’ subjective perceptions of political risk – not just the level of risk – are important for how firms manage political risk. The importance attributed to political risk by corporate executives has increased over the last 15 years and our results show that political risk is now considered more important than commodity (input) risk. Our analysis suggests that nearly 50% of firms avoid (not simply reduce) foreign direct investment because of political risk. Using a unique survey-based psychometric evaluation of manager risk aversion, we show that firms with risk averse executives are more likely to avoid investment in politically risky countries – a key implication of behavioral models. This relation is economically stronger when agency problems are more likely to be severe: for example, when executives are less aligned with shareholder value maximization, and when executives are younger (and therefore might put their personal career’ concerns in front of shareholders’ interests). While numerous studies have shown that political risk affects foreign direct investment using objective measures of such risk (electoral uncertainty, conflicts, etc.), our study documents that executives’ subjective perceptions of political risk are also important for political risk management.

The Management Of Political Risk – Introduction

How does political risk affect foreign direct investment (FDI)? In an influential study, Kobrin (1979) argues that political risk affects FDI by increasing the uncertainty that firms face in a foreign country. To investigate this relation empirically, researchers have traditionally used objective measures of political risk, including 1) electoral uncertainty 2) conflict risks, 3) social unrest, 4) corruption, 5) political instability, 6) quality of the institutions in the host country, 7) sovereign debt default risk, and 8) market imperfections.1 In this paper, we address a classic research challenge put forth by Kobrin (1979); namely, we attempt to directly assess “what affects managers’ subjective perceptions” of political risk. To overcome the difficulty in measuring subjective preferences, we administer a psychometric test to evaluate the risk aversion of individual executives. We show that the personal risk aversion of executives is a significant factor explaining how their companies respond to political risk.

We study these issues within the context of behavioral theory (e.g., Johnson and Tversky, 1983; Slovic, 1987) and agency theory (e.g., Stulz, 1984; and Smith and Stulz, 1985). Behavioral models predict  that it is not just the level of political risk that is important, it is also the individual manager’s sensitivity to that risk that dictates the corporate response to political risk. According to agency theory, corporate decisions are more likely to reflect the best interests of executives (rather than the best interests of shareholders) when managers’ interests are less aligned with those of stockholders. Thus, corporate corporate risk management decisions will reflect an executive’s personal sensitivity to political risk in firms in which executives indicate that they are less concerned about the interest of stockholders and in firms managed by younger executives – who put their own career concerns ahead of the interests of shareholders. We develop these two main hypotheses, one behavioral and one agency?driven, in more detail in the next section.

Political Risk, Risk Management, Hedging

In our empirical work, we find that nearly half of the executives in our sample say that they avoid investing in a risky country altogether as a way to manage political risk. Consistent with a behavioral prediction, we find that companies with highly risk?averse financial executives are more likely to avoid investment in politically risky countries. That is, a manager’s subjective perception of political risk affects her firm’s decision to avoid investment in a politically risky country. Consistent with an agency theory prediction, we find that the effect of risk aversion on a firm’s decision to avoid investing in a politically risky country is stronger for executives who are less concerned about stockholder welfare, and is also stronger for younger executives.

While numerous studies have documented the effect political risk on FDI using objective measures of such risk (conflicts, social unrest, electoral uncertainty, etc.), our paper documents that a manager’s subjective perception of political risk is also important for how firms manage political risk. The paper is organized as follows. We develop our hypotheses in section 2. The data are described in the third section. The forth section presents empirical results. Some concluding remarks are made in the final section. The survey questions are in the appendix.

Political Risk, Risk Management, Hedging

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