Economic Risk

Updated on April 10, 2024
Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

Economic Risk Definition

Economic risk is referred to as the risk exposure of an investment made in a foreign country due to changes in the business conditions or adverse effect of macroeconomic factors like government policies or collapse of the current government and significant swing in the exchange rates.

Economic Risk

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Economic risk can be mitigated by investing in international mutual funds, which enable them to invest in many products, thereby reducing the losses arising from an unforeseen event. However, it is the most challenging risk to foresee, and hence mitigating or formulating plans to control the risk is a difficult task.

Key Takeaways

  • Economic risk refers to the potential for adverse changes in economic conditions that can negatively impact businesses, industries, and economies.
  • Economic risks can arise from various factors such as recessions, inflation, exchange rate fluctuations, political instability, trade disputes, regulatory changes, and natural disasters.
  • Managing economic risk involves assessing and understanding the potential impacts of these factors on financial performance, making informed decisions, diversifying investments, implementing risk mitigation strategies, and monitoring economic indicators.
  • Economic risk affects individuals, businesses, investors, and governments, and it plays a crucial role in financial planning, investment decision-making, and policy formulation.

Economic Risk Explained

Economic risk is the risk involved in investing in a business opportunity in an international market that arises from changes in sovereign policies, market fluctuations, and counterparty credit risk. It makes a native investment look attractive than an international investment due to its calm nature and reduced risk for an investor.

Like all other risks, macro economic risk can be mitigated by investment options like international mutual funds, which facilitate diversification by allowing investment in various products at a time.

Economic risk factors can also be mitigated by investing in insurance, covering the losses arising out of a counterparty defaulting to pay its obligation. Hedging activities against exchange rate fluctuation will prove worthwhile to mitigate the risk.

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Types

Many factors can be a cause of macro economic risk, although the chances mentioned below are not an exhaustive one. The following are types of Financial Risk.

Economic Risk

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#1 – Sovereign Risk

This type of economic risk is one of the most critical risks that can have a direct impact on the investment since the repercussions arising out of these risks can trigger other troubles that are related to the business. Sovereign Risk is the risk that a government cannot repay its debt and default on its payments. When a government becomes bankrupt, it directly impacts the businesses in the country. Sovereign Risk is not limited to a government defaulting but also includes the political unrest and change in the policies made by the government. A change in government policies can impact the exchange rate, which might affect the business transactions, resulting in a loss where the business was supposed to make a profit.

#2 – Unexpected Swing in Exchange Rate

This type of sovereign risk is if the market moves drastically to impact the exchange rate. When the market moves considerably, it affects international trade. This can be due to speculation or the news that can cause a fall in demand for a particular product or currency. For example, oil prices can significantly impact the market movement of other traded products. As mentioned above, government policies can also result in a dip or hike in the market movement. Changes in inflation, interest rates, import-export duties, and taxes also impact the exchange rate. Since this directly impacts trade, exchange rates risk seeming to be a significant, economic risk in business.

#3 – Credit Risk

This type of sovereign risk is the risk that the counterparty will default in making the obligation it owes. Credit risk is entirely out of control since it depends on another entity’s worthiness to pay its debts. The counterparty’s business activities need to be monitored on a timely basis so that the business transactions are closed at the right time without the risk of counterparty default to make payments.

Examples

Let us try to understand the concept of economic risk analysis with the help of some suitable examples.

Example#1

In 2016, Invexstar Capital Management failed to make payments for the trades it had done. The company’s sole trader only settled those trades which were profitable for his company and refused to make payments for any of the loss-making transactions. This resulted in a chain reaction of losses for the banks dealing with an investor. Market-making banks were impacted economically, which summed up to £120 million. This rogue trading caused regulatory repercussions and also resulted in traders from the banks being sacked for bad KYC checks being done for the clients.

The impact of counterparty default might result in a collapse in the whole market, causing market conditions to worsen and stricter trade laws being implemented to curb such payment defaults.

Example#2

The debt crisis of the Greek government during early 2009 to late 2018, which occurred as an aftermath of the financial crisis of 2007, had occurred because of improper management of funds and lack of flexibility in the monetary policies. The Greek banks could not repay their debts and, as a result, led to a crisis.

The government had to levy increased taxes and reduce the facilities provided to its citizens, which triggered an outrage. The crisis not only disturbed the wellbeing of the local people but also impacted international trade. It brought the turmoil under control by negotiating a 50% haircut for its existing debts owed and by new loans provided by European banks.

Example#3

A US microchip manufacturer imports electrical circuits from a Chinese manufacturer, places an order for CNY 300,000 today, and agrees to pay after 90 days. At the current market price, it would be roughly $43,652, which is CNY 6.87 per dollar. If the market price for yen moves above 6.87, the payment to be made will be above $43,652, whereas if the market price for yen moves below 6.87, the cost to be made will fall below $43,652.

Advantages

Like every concept has its own advantages and disadvantages, so does this concept. Let us first try to understand the advantages of the concept.

  • High risk always has a higher potential for returns. Therefore, taking on investments with high economic risk factors is always profitable because they can give higher returns.
  • Businesses or entrepreneurs ready to take on innovation projects involving higher economic risk in business can introduce new technology or product ranges in the market, creating better employment opportunities and growth.
  • This kind of risk encourages competition, improves efficiency and leads to better and more range of consumer choices.
  • It motivates businesses to diversify their investments and operations so that the risk gets mitigated or controlled to to a great extent.

Disadvantages

It is also important to look at the disadvantages of the economic risk analysis to get a comprehensive idea about it. Let us go through some disadvantages  as given below:

  • Economic risk can cause the downfall of not just the business but the whole market resulting in unemployment, recession, etc.
  • Although economic risk can be mitigated, it cannot be negated entirely.
  • Economic risk impacts international trade and has the potential to create a lasting effect on the business activities of all participants.
  • It creates volatility and uncertainty in the market, and in the process, any decision-making and planning become very challenging and unpredictable.

Frequently Asked Questions (FAQs)

How does economic risk differ from other types of risks?

Economic risk differs from other types of risks as it specifically relates to the potential impact of macroeconomic factors, such as changes in interest rates, inflation, or exchange rates, on business operations and financial outcomes. It is broader in scope and encompasses systemic risks that can affect entire industries or economies, making it vital for businesses to assess and manage these risks to ensure resilience and long-term stability.

How can businesses mitigate economic risk?

Businesses can mitigate economic risk by diversifying their operations across multiple markets, implementing effective hedging strategies to manage currency and interest rate fluctuations, and closely monitoring economic indicators to adjust their strategies and operations proactively.

How does economic risk impact different types of investments?

Economic risk can impact different types of investments by affecting market demand, consumer spending power, and the overall economic environment, influencing the profitability and performance of stocks, bonds, real estate, and other investment assets.

This has been a guide to Economic Risk and its definition. We explain it with examples, along with types, advantages and disadvantages. You can learn more about risk management from the following articles –