Question

BFRC Auditing (BFRC-Partners) Company, originated in Germany, would like to assess the country risk of Turkey. BFRC-Partners has identified various political and financial risk factors after Covid-19, as shown below. BFRC-Partners has assigned an overall rating of 80 percent to political risk factors and of 20 percent to financial risk factors. BFRC-Partners is not willing to consider Turkey for investment if the country risk rating is below 4.0. Should BFRC-Partners consider Turkey for investment?

POLITICAL RISK FACTORS	ASSIGNED RATING	ASSIGNED WEIGHT
Factor 1	5	40 %
Factor 2	3	60 %

FINANCIAL RISK FACTORS	ASSIGNED RATING	ASSIGNED WEIGHT
Factor 1	1	10%
Factor 2	4	20%
Factor 3	5	30%
Factor 4	4	20%
Factor 5	5	20%

1. Calculate the country risk of Turkey and decide whether to invest or not to this country.
2. Explain why foreign exchange rates are important for investment? Please explain it.
3. Why companies need to forecast Exchange rates? Is it easy to estimate the Exchange rate?

Answer 1

1). Average political risk = sum of [factor rating*assigned weight]

= (5*0.4)+(3*0.6) = 3.8

Average financial risk = sum of [factor rating*assigned weight]

= (1*0.1) + (4*0.2) + (5*0.3) + (4*0.2) + (5*0.2) = 4.2

Country risk rating = average political risk*weight of political risk + average financial risk*weight of financial risk

= (3.8*0.8) + (4.2*0.2) = 3.88

Turkey has a risk rating of 3.88 which is less than 4 so Turkey should not be considered for investment.

2). Investments in foreign countries have the additional risk of exchange rate changes. If the foreign currency depreciates in value then the investment value will decrease and if the foreign currency appreciates then the investment value will increase. This fluctuation is over and above the return which the investment would be earning in the foreign country. So, in case, of foreign investments, the return which it earns may not be the return which the investor gets due to exchange rate fluctuations. This is why, exchange rate risk is hedged.

3). Companies (especially MNCs/importers/exporters) need to forecast exchange rates because their operations and financing happen in different currencies so they need to know a reasonable estimate of exchange rates in order to make short-term financial/investment decisions, hedging decisions, earnings decisions, capital budgeting and long term investment decisions.

4). Exchange rates can be forecasted using technical forecasting, fundamental forecasting or market based forecasting. Since exchange rates depend on so many factors such as inflation, interest rates, etc., it is challenging to exactly forecast the rates and requires considerable skill & expertise.