Geopolitical Tensions: The Root Of Global Investment Risk

Global investment risk is a broad term that encompasses a variety of international risk factors, including currency risks, political risks, and interest rate risks. Currency risk is associated with fluctuations in foreign currencies relative to a given domestic currency, such as the US dollar. Political risk is associated with foreign governments and politics, where political changes may lead to business losses. Interest rate risk involves changes to monetary policy, where an increase in interest rates could negatively impact the value of financial assets. These risks are important to consider for investors looking to invest globally, as they can significantly impact the performance of their investments.

Currency risk

For example, a foreign company may report impressive earnings growth, but if the local currency depreciates relative to the US dollar, the real growth rate will be lower when those profits are converted back into US dollars. This uncertainty around exchange rates can deter investors from venturing into foreign markets.

Additionally, investing globally can be a prudent strategy for managing currency risk. By diversifying across different geographic regions, investors can reduce their exposure to fluctuations in any single currency. However, it is important to note that investing in global markets also comes with higher transaction costs and other challenges, such as accessing information and understanding foreign market dynamics.

Political risk

To manage political risk, investors should consider diversifying their portfolios and hedging their investments. Additionally, investors can purchase political risk insurance to mitigate potential losses. When evaluating political risks, it is essential to consider the host country's track record, including its attitude towards foreign direct investment (FDI) and foreign investors, as well as its political and regulatory stability.

Interest rate risk

The increase in interest rates can negatively affect banks in multiple ways. While lenders benefit from higher interest rates on loans, they must also pay higher rates on deposits. Additionally, banks with significant bond holdings may suffer losses as bond prices tend to drop when interest rates rise. This can lead to a loss of confidence among customers, resulting in sudden withdrawals and further straining the bank's liquidity. In extreme cases, as seen with the Silicon Valley Bank, this can lead to bank failures.

To manage interest rate risk, central banks and financial supervisors must employ analytical tools and regulatory responses. Stress-testing tools and surveillance mechanisms are crucial for identifying vulnerable lenders and assessing the impact of rising interest rates on their capital, earnings, and liquidity. These assessments help identify weaknesses and implement measures to enhance resilience, such as improving access to central bank lending facilities.

International investors need to carefully consider interest rate risk when investing globally. An increase in interest rates in a foreign market can negatively impact the value of their investments. This is particularly relevant when investing in emerging markets, where a sudden decision to hike interest rates to control inflation could lead to a decline in the value of financial assets.

To mitigate interest rate risk, investors can diversify their portfolios globally and use tools like currency hedging or investing in American depositary receipts (ADRs) to reduce exposure to currency fluctuations. However, it's important to note that ADRs still carry currency risk as their value is tied to the foreign company's stock performance.

Higher transaction costs

Transaction costs are a significant barrier to investing in international markets. Despite increased globalisation and connectivity, transaction costs can vary greatly depending on the foreign market. Brokerage commissions in international markets are typically higher than US rates, and there may be additional local charges such as stamp duties, levies, taxes, clearing fees, and exchange fees.

For example, a US investor purchasing a single stock in Hong Kong would pay a brokerage commission of approximately $38.28 per trade, based on the exchange rate on 20 July 2023.

Additionally, fund managers or professional managers will charge higher fees to cover the increased time and resources spent on research and analysis for international investments. This includes hiring analysts and researchers familiar with the market, as well as professionals with expertise in foreign financial statements, data collection, and administrative services.

One way to minimise these higher transaction costs is to invest in American Depositary Receipts (ADRs). These are negotiable financial instruments issued by US banks that represent a foreign company's stock but trade as US stocks, eliminating foreign exchange fees. However, investors in ADRs are still vulnerable to currency price fluctuations.

Transaction costs are a critical component in the risk management of investment projects. They can be divided into groups based on the phase of the investment project, and they play a significant role in selecting investment projects with the best characteristics in terms of acceptable risk levels.

Liquidity risk

Market liquidity risk occurs when an enterprise cannot execute transactions at current market prices due to insufficient market depth or disruptions. In other words, it is the inability to sell an investment due to a lack of liquidity in the market. This can be a significant issue for investors in foreign markets, especially emerging markets, as they may not be able to sell their investments quickly without incurring substantial losses due to political or economic crises.

Funding liquidity risk, on the other hand, is the inability to obtain sufficient funding to meet financial obligations. This can happen when an institution is unable to obtain funds, such as customer deposits or borrowed funds, at a reasonable price or within the required timeframe. Funding liquidity risk can be a concern for both financial institutions and corporations, threatening their operational and financial stability.

Effective liquidity risk management is crucial for mitigating these risks. This includes ensuring access to sufficient cash, liquid assets, and borrowing lines to meet both expected and unexpected liquidity needs. Additionally, maintaining a portfolio of high-quality liquid assets, employing rigorous cash flow forecasting, and diversifying funding sources can help manage liquidity risk.

The consequences of poorly managed liquidity risk can be severe and far-reaching. It can lead to financial losses, operational disruptions, and reputational damage. In extreme cases, liquidity risk can even drive an entity towards insolvency or bankruptcy.

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