Foreign Investment: Unique Risks And Challenges

Investing in foreign markets is a great way to diversify an investment portfolio, but it also comes with a unique set of risks. These risks can be broadly categorised into market, economic, currency, and political risks. Market risk refers to the liquidity of the market, which can vary depending on the level of development of the economy. Economic risk relates to a country's ability to pay back its debts and the stability of its economy. Currency risk is the potential for losses due to exchange rate volatility when converting between currencies. Political risk refers to the decisions made within a country that may impact investors, such as regulatory changes or an unfavourable climate for foreign investment. Other risks include higher transaction costs, challenges with accessing information, and difficulties finding legal remedies.

Higher transaction costs

Investing in international markets can be costly. Brokerage commissions for international markets are almost always higher than U.S. rates, and there may be additional charges such as stamp duties, levies, taxes, clearing fees, and exchange fees. Fund managers or professional managers will also charge higher fees due to the extra time and money spent on research and analysis, including hiring analysts and researchers familiar with the market.

For example, a U.S. investor looking to purchase stock in Hong Kong could expect to pay around $38.28 in fees per trade, based on the exchange rate on July 20, 2023.

One way to minimize these costs is to invest in American depositary receipts (ADRs). These are negotiable financial instruments issued by U.S. banks that represent a foreign company's stock but trade as U.S. stocks, eliminating foreign exchange fees. However, investors choosing this option are still vulnerable to currency price fluctuations.

Another factor contributing to higher transaction costs is the role of the fund manager or financial advisor. The process of recommending international investments involves significant time and money spent on research and analysis, including hiring analysts and researchers familiar with the market. This additional expertise comes at a cost, which is passed on to the investor in the form of higher fees.

It is also worth noting that the fees associated with international investing may be less transparent than those for domestic investments. The financial statements of foreign companies may be prepared using different accounting standards and rules, making it challenging to fully understand the fees involved.

Overall, investors considering international markets should be prepared for higher transaction costs and carefully evaluate the potential impact on their investment returns.

Currency volatility

For example, an investor might buy 1,000 euros worth of French stocks when the exchange rate is €1.00 = $1.00. A year later, they decide to sell the stock, and the price is still €1,000. However, the exchange rate has changed, and now €1.00 = $0.87. Even though the stock price remained the same, the investor will only receive $870 when they convert their money back to US dollars. In this case, the investor incurred a loss due to currency volatility, not because the value of their investment decreased.

Various factors influence currency volatility, including central bank monetary policies, interest rate decisions, inflation rates, trade balances, international economic events, and crude oil prices. Higher interest rates generally attract foreign capital and strengthen a country's currency, while lower rates typically lead to lower prices. Central banks can also directly intervene in the market by buying or selling currencies to influence pricing and volatility. Additionally, countries with higher inflation tend to have weaker currencies compared to those with lower inflation.

To manage currency volatility, investors can use tools such as currency futures, options, and forwards and currency exchange-traded funds (ETFs). These strategies help hedge currency exposure and reduce the risk associated with exchange rate fluctuations.

Liquidity risk

This risk can be further divided into two main types: market liquidity risk and funding liquidity risk. Market liquidity risk occurs when an enterprise cannot execute transactions at current market prices due to insufficient market depth or disruptions. Funding liquidity risk, on the other hand, is the inability to obtain sufficient funding to meet financial obligations.

Market liquidity risk is especially relevant in the context of foreign investments. Foreign markets, particularly emerging markets, may lack the substantial trade volume that keeps more developed markets liquid. This means that investors may struggle to sell their investments without incurring substantial losses due to political or economic crises.

The impact of liquidity risk can be severe, leading to financial losses, operational disruptions, and reputational damage. In extreme cases, it can even drive entities towards insolvency or bankruptcy.

To manage liquidity risk, investors can employ strategies such as maintaining a portfolio of high-quality liquid assets, using liquidity ratios, conducting stress testing, and diversifying funding sources.

Information access and comparability

In the United States, financial statements are prepared using Generally Accepted Accounting Principles (GAAP), a set of standardised rules that frame accounting judgments. These statements are often audited by independent certified public accountants (CPAs) to ensure compliance with accounting rules. However, in other countries, different accounting standards and regulations may be used, which can impact the comparability of financial information. For example, differences in asset valuation methods between countries can significantly impact investment decisions. As such, it is important for investors to be mindful of the distinct accounting rules and standards applied in other countries and to assess the potential impact on the interpretation of financial reports.

Another factor to consider is the availability and transparency of information. In the US, the Securities and Exchange Commission (SEC) requires companies to file annual and quarterly reports, making information readily available to the public. However, other countries may not have similar corporate filing requirements, leading to challenges in accessing information. Additionally, the information that is available may not be as comprehensive or uniformly presented, making it more difficult for investors to make informed decisions.

To address these challenges, investors can engage with brokerage or advisory firms that have analysts and researchers with on-the-ground experience in the relevant foreign countries. These professionals can provide valuable insights into the economic, cultural, and corporate landscapes, helping investors make more informed decisions.

Furthermore, investors should also be aware of potential language barriers when accessing information from foreign sources. Information may not always be available in English, and translation services may be required to interpret financial reports and other relevant data accurately.

In summary, when considering foreign investments, it is crucial to assess the accessibility, transparency, and comparability of information. By understanding the distinct accounting standards, regulatory requirements, and cultural contexts of the target country, investors can make more informed decisions and mitigate the risks associated with information access and comparability.

Regulatory environments

One of the key risks is the lack of information or difficulty in accessing information. In the US, there is an abundance of information available on publicly traded assets due to stringent regulatory requirements. However, other countries may have more opaque rules and regulations, making it challenging for investors to gather the information needed to make informed investment decisions.

Additionally, the information provided by foreign companies may be prepared using different accounting standards and rules. For example, in the US, financial statements are prepared using Generally Accepted Accounting Principles (GAAP), while this may not be the case in other countries. As a result, interpreting financial reports from foreign companies can be challenging, and investors need to be mindful of potential differences in valuation methods and other key factors.

Differences in regulatory enforcement and judicial processes can also impact investment risk. Inconsistent or arbitrary enforcement of rules and a lack of respect for the rule of law can increase investment risk and make it difficult to resolve disputes.

The level of economic freedom in a country can also impact investment risk. The Index of Economic Freedom (IEF), created by the Heritage Foundation and the Wall Street Journal, measures a country's welcoming of investment and encouragement of economic growth. Countries with higher economic freedom may provide a more stable and favourable environment for investors, while those with lower economic freedom may present more regulatory challenges.

Another risk to consider is the potential for government intervention and over-regulation, which could stifle liquidity and increase the potential for corruption. In countries with excessive regulation, there may be more opportunities for bribery, favouritism, and corruption, raising transaction costs and discouraging investment.

Lastly, political risks, such as geopolitical tensions and autocratic rule, can also impact foreign investments. For example, the Russian-Ukrainian conflict led to economic sanctions and measures that harmed foreign investors with assets in Russia.

Overall, investors need to carefully consider the regulatory environment of a country before investing and be aware of the potential risks associated with different levels of economic freedom, regulatory enforcement, and political stability.

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