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MITIGATING FINANCIAL RISKS AND ASPECTS TO BE ADDRESSED IN
MAKING FOREIGN INVESTMENTS
Ruziokhunov Doniyorbek
Tashkent State University of Economics
https://doi.org/10.5281/zenodo.14412680
Annotation:
The globalization of financial markets has led to increased cross-border
investments, enabling investors to access new growth opportunities. However, foreign
investments are riskier than domestic ones due to factors such as political instability,
currency fluctuations, and differing regulatory environments. This thesis will explore these
financial risks, propose methods for mitigating them, and highlight the critical factors
investors must address when considering foreign investments.
Keywords:
Global financial markets, foreign investments, investment risks, financial
institutions, risk management tools and tactics.
Introduction
Global financial markets have opened ways for investors to diversify their portfolio and
reap the benefits of foreign markets. Technology made the investment process
straightforward and dynamic that investors now are able to access different stock markets
and do their transactions from any place of the world. International markets are attractive to
many investors because they could get more profit than investing only in their home country.
Foreign investment opportunities also come with specific risks and in this thesis, we are going
to explore foreign investment risks and ways of mitigating them.
The Financial Risks in Foreign Investment
Investors need to consider different risks when making international investments.
These risks may range from economic risk of a country, political risk or exchange rate risk and
so on. Now let’s define different risks investors should assess before entering internation
financial markets:
Political Risk
Political risk refers to the possibility that political changes or instability in a country
could adversely affect an investment. This can include expropriation of assets, changes in tax
policy, or sudden shifts in government regulations.
For example, in 2008, the Venezuelan government expropriated several oil companies,
including those with foreign investments, causing substantial financial losses. For instance,
ExxonMobil's operations in Venezuela were valued at approximately $1.5 billion, which were
seized as part of the nationalization process.
Currency Risk
Currency risk, or exchange rate risk, arises from the fluctuation of currency values. An
investor holding foreign assets is exposed to the possibility of the local currency weakening
relative to their home currency, which can lead to losses.
Between 2014 and 2016, the Russian ruble lost nearly 50% of its value against the U.S.
dollar, significantly affecting the returns of foreign investors in Russian assets. A U.S. investor
holding 1 million rubles at the beginning of 2014 would have seen its value drop from
$28,000 to $14,000 by 2016, assuming the exchange rate was 35 rubles to the dollar initially
and 70 rubles to the dollar in 2016.
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Market and Liquidity Risk
Market risk refers to the potential for an investment to decline in value due to changes
in market conditions, while liquidity risk is the risk that an investor may not be able to sell an
asset quickly at a reasonable price. The main driver of market risk are interest rates, foreign
exchanges, commodity prices, equity prices.
Regulatory and Legal Risk
Different countries have varying regulations related to foreign investment, taxes,
property rights, and repatriation of profits. A change in regulations could impact the
profitability or even the viability of an investment.
Interest Rate Risk
Interest rate risk arises from the potential for changes in interest rates that affect the
cost of borrowing or the discount rate applied to future cash flows. This risk is particularly
important for foreign investments in countries with unstable monetary policies.
Mitigation Strategies for Financial Risks
Risks are inevitable part of any investment. They cannot be eliminated but through
careful management they can be mitigated. If the investment were risk free, everyone would
be investing in the same stock or bond. In real life if you want to gain high profit, you have to
bear high risk. There are some risk management techniques and tools in financial markets to
reduce risk exposure of investments.
Insurance and hedging - to mitigate political risk, investors can purchase political risk
insurance from institutions like the Multilateral Investment Guarantee Agency (MIGA) or use
hedging strategies such as options and futures contracts to protect against adverse political
developments.
Currency hedging - to protect against currency fluctuations, investors can use hedging
instruments such as forward contracts, options, and currency swaps.
Diversification and asset allocation: diversification across different asset classes,
sectors, and geographic regions can help reduce both market and liquidity risks. Allocating
investments into a mix of stocks, bonds, real estate, and commodities in different countries
can cushion the portfolio from localized risks.
Regulatory understanding: foreign investors should conduct thorough legal due
diligence, including understanding the host country’s regulatory environment and property
rights protections. Additionally, building strong relationships with local legal advisors and
government agencies can help navigate potential legal and regulatory risks.
Investors must conduct detailed research on the economic environment of the foreign
country. This includes GDP growth rates, inflation, employment rates, and sector-specific
trends.
Before making an investment, investors must carefully weigh the risk against the
potential return. Financial models such as the Capital Asset Pricing Model (CAPM) or the
Internal Rate of Return (IRR) can assist in this evaluation.
Investing in a foreign country often requires partnering with local firms. Proper vetting
of these partners and understanding their governance structures are critical to ensuring
compliance and aligning business interests.
Conclusion
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Foreign investments hold significant promise for capital growth, but they are fraught
with unique risks. Political instability, currency fluctuations, regulatory uncertainty, and
market volatility are just a few of the challenges that must be mitigated. By employing a
variety of risk mitigation strategies such as hedging, diversification, and thorough due market
analysis, investors can reduce the likelihood of adverse outcomes. Furthermore,
understanding the key aspects of the local economic, legal, and market environments is
essential to ensuring that foreign investments yield optimal returns.
References:
1.
Barclays, 2018. Currency Risk Management. Barclays Research. Available at:
https://www.barclays.com [Accessed 7 November 2024].
2.
International Monetary Fund (IMF), 2020. World Economic Outlook: Global Financial
Stability
Report.
International
Monetary
Fund.
Available
at:
https://www.imf.org/en/Publications/WEO [Accessed 7 November 2024].
3.
Multilateral Investment Guarantee Agency (MIGA), 2012. Political Risk Insurance. World
Bank Group. Available at: https://www.miga.org [Accessed 7 November 2024].
4.
International Monetary Fund (IMF), 2009. The Financial Crisis and the Global Economy.
International Monetary Fund. Available at: https://www.imf.org [Accessed 7 November
2024].
