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.
Types of Economic Risk
Many factors can be a cause of economic risk, although the chances mentioned below are not an exhaustive one. The following are types of Financial Risk.
#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 RiskSovereign RiskSovereign Risk, also known as Country Risk, is the risk of a country defaulting on its debt obligations. It is the broadest measure of credit risk and includes country risk, political risk, and transfer 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 transactionsBusiness TransactionsA business transaction is the exchange of goods or services for cash with third parties (such as customers, vendors, etc.). The goods involved have monetary and tangible economic value, which may be recorded and presented in the company's financial statements., resulting in a loss where the business was supposed to make a profit.
The debt crisis of the Greek government during early 2009 to late 2018, which occurred as an aftermath of the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors. 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, lead 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 tradeInternational TradeThe trading or exchange of products and/or services across international borders is referred to as international trade. It frequently includes other risk factors such as exchange rate, government policies, economy, laws of the other nation, judicial system, and financial markets that impact trade between the two.. It brought the turmoil under control by negotiating a 50% haircut for its existing debts owed and by new loans provided by European banks.
#2 – Unexpected Swing in Exchange Rate
This type of sovereign risk is the risk 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. 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. Change in inflation, interest rates, import-export duties, and taxes also impact the exchange rate. Since this directly impacts trade, exchange rates riskExchange Rates RiskExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies. seeming to be a significant economic risk.
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.
#3 – Credit Risk
This type of sovereign risk is the risk that the counterparty will default in making the obligation it owes. Credit riskCredit RiskCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection. 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 it payments.
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.
Some disadvantages are:
- Economic risk can cause the downfall of not just the business but the whole market.
- 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.
- Economic risk is the most challenging risk to foresee, and hence mitigating or formulating plans to control the risk is a challenging task.
- Like all other risks, economic risk can be mitigated by investment options like international mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks., which facilitate diversification by allowing investment in various products at a time.
- Economic risk can also be mitigated by investing in insurance, covering the losses arising out of a counterparty defaulting to pay their obligation.
- HedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. activities against exchange rate fluctuation will prove worthwhile to mitigate the risk.
- 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.
- Economic risk makes a native investment look attractive than an international investment due to its calm nature and reduced risk for an investor.
- Economic risk can be mitigated by investing in international mutual funds which enable to invest in a plethora of products, thereby reducing the losses arising out of an unforeseen event.
This has been a guide to what is Economic Risk and its definition. Here we discuss types of economic risk along with examples and disadvantages. You can learn more about risk management from the following articles –