Question

Question 9: Classification of political risks are - [5 pts]

O Industry specific, country specific & firm specific

O Country specific, factory specific & firm specific

O Firm specific, industry specific & Global specific

O Global specific, country specific & firm specific

Question 10: One of the major criticisms of Modern Portfolio Theory on its assumption that - [5 pts]

O If something has not happened in the past, it cannot happen in the future

O Diversified portfolio always provides better returns on investments.

O If something has happened in the past, it cannot happen in the future

O If something has not happened in the past, it can happen in the future

Answer 1

(1) Classification of political risks are :- (d) Global specific, country specific & firm specific

In a globalized economy & international business, the multinational companies are largely susceptible to political risks. Political risks mainly arise from the changes in the political regimes in a country and thus the resulting change in the government policies. The changes in the political environment of a country adversely affect the firm’s value. Political risks arise when the foreign/host country govt. intervenes in the operations of an MNC that is perceived to be unfair, discriminatory, costly for the MNC. The govt.’s various policy changes in terms of changes in tax regulations, restrictions on deposits & borrowings, foreign exchange control, expropriation, changes in the FDI limit, stipulated local productions, trade tariffs, labour laws, environmental regulations etc. may adversely affect the investment returns of a multinational firm.

Political risks can be viewed on both macro level & micro level. Macro level political risks affect all the firms in the foreign/ host country irrespective of its industry. Micro risks are a project, firm or industry specific risk. Hence, political risks can be categorized into the following types:-

Firm specific – these are the micro level political risks that arise when an MNC’s business interests has a direct conflict with the host country’s governance policies (like the monetary, fiscal, balance of payment policies, bureaucratic red tapes, protectionism for the local companies, project-specific environment related local protests, trade union unrests & wage related issues etc.). For example, in 1992 US based Enron invested 3 billion US dollars to set up a mega power project in India, but due to change in the local govt. regime, the initial agreement between the co. and the state govt. got affected later on which resulted in long drawn court cases and finally the takeover of the project by other companies.

Country specific - these are macro level political risks that originates from the host country. Some of the example like bureaucratic corruption practices, intellectual property rights, patent policies, protectionist attitude of the govt, sovereign credit risks, ownership structure etc., capital control & exchange control policies, civil unrests etc. For example, after 1949, the capitalistic environment in the China was completely overthrown an got replaced by the Communist party regime which gradually nationalized all the foreign assets with a very little compensation to the institutional investors.

Global specific risks are also macro level political risks that arise from the factors like terrorism, cyber attacks, climate change and environment concerns, imperialistic attitude of the host countries, pandemics, poverty etc. Example – The Covid - 19 pandemic has got affected all the MNCs & the financial markets all over the world shrinking their overall profits & jobs in 2020 as well as for the coming 2-3 years.

(2) One of the major criticisms of Modern Portfolio Theory on its assumption is that :-

If something has not happened in the past, it cannot happen in the future

Markowitz Modern Portfolio theory helps an investor to understand the concept of risk- return trade- off. It proposes the creation of a diversified portfolio consisting of assets that would maximize return for a desired level of risk for the investor. Some of the assumptions of the modern portfolio theory are like –

The investors are rational and avoid high level of risks
The market prices cannot get affected by single investors
There is free flow of capital at tax free borrowing rates
Asset returns are normally distributed
Investors seek to maximize their returns for a given level of risk.
There is no information asymmetry
Taxes & trading costs are not considered

MPT theory mainly states that the overall expected return of a portfolio is derived from the weighted average of the expected returns of the individual assets contained in that portfolio.

However the Modern Portfolio theory is criticized for its assumption that the correlation of risk & return between the different assets are fixed and predictable. The correlations between the risk-return of different assets are basically derived from the predictions about the future financial market movements based upon the past historical data. This assumption of the MPT that what happened in the past would again happen in the future & what has not happened in the past will never happen in the future, just not hold true in the ever changing financial climate. The buy - and-hold investment tactic of the MPT doesn’t always work with the help of the financial data that is derived from the past. One cannot always make timely investment decisions if his/her entire understanding of the behaviour of asset prices and market volatility is based upon the past record.