science

Political risk

Political risk is a science topic covered in the lgStudy science library. This page brings together a partial reference excerpt, illustrations, worked examples, real-world applications and a short study plan, so you can understand Political risk rather than just read about it. In short: Political risk is a type of risk faced by investors, corporations, and governments that political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected value of a given economic action. Political risk can be understood and managed with reasoned foresight and investment.

Key takeaways

Political risk belongs to science; place it in that map before memorising details.
Learn the definition first, then one example that makes the definition concrete.
Connect Political risk to a quantity you can measure, compute or draw — that is where exam questions come from.
Reproduce the core statement of Political risk from memory before moving on to harder problems.

Reference excerpt

Political risk is a type of risk faced by investors, corporations, and governments that political decisions, events, or conditions will significantly affect the profitability of a business actor or the expected value of a given economic action. Political risk can be understood and managed with reasoned foresight and investment. The term political risk has had many different meanings over time. Broadly speaking, however, political risk refers to the complications businesses and governments may face as a result of what are commonly referred to as political decisions—or "any political change that alters the expected outcome and value of a given economic action by changing the probability of achieving business objectives". Political risk faced by firms can be defined as "the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and developmental), or events related to political instability (terrorism, riots, coups, civil war, and insurrection)." Portfolio investors may face similar financial losses. Moreover, governments may face complications in their ability to execute diplomatic, military or other initiatives as a result of political risk. The field has historically focused on analyzing political risks predominantly in emerging economies, but such risks also exist in developed economies and liberal democracies as well, albeit in different manifestations. The term is used in the sense of downside risks but political actions or developments can also create upside risks or opportunities for companies and governments. A low level of political risk in a given country does not necessarily correspond to a high degree of political freedom. Indeed, some of the more stable states are also the most authoritarian. Long-term assessments of political risk must account for the danger that a politically oppressive environment is only stable as long as top-down control is maintained and citizens prevented from a free exchange of ideas and goods with the outside world. Understanding risk partly as probability and partly as impact provides insight into political risk. For a business, the implication for political risk is that there is a measure of likelihood that political events may complicate its pursuit of earnings through direct impacts (such as taxes or fees) or indirect impacts (such as opportunity cost forgone). As a result, political risk is similar to an expected value such that the likelihood of a political event occurring may reduce the desirability of that investment by reducing its anticipated returns. There are both macro- and micro-level political risks. Macro-level political risks have similar impacts across all foreign actors in a given location. While these are included in country risk analysis, it would be incorrect to equate macro-level political risk analysis with country risk as country risk only looks at national-level risks and also includes financial and economic risks. Micro-level risks focus on sector, firm, or project specific risk. Political risk insurance can be taken out to protect again political risk such as inconvertibility of funds, expropriation, and losses due to violent conflict. Claims due to political risk decrease with political constraints and increase with changes of political leadership in the country.

Macro-level Macro-level political risk looks at non-project specific risks. Macro political risks affect all participants in a given country. A common misconception is that macro-level political risk only looks at country-level political risk; however, the coupling of local, national, and regional political events often means that events at the local level may have follow-on effects for stakeholders on a macro-level. Other types of risk include government currency actions, regulatory changes, sovereign credit defaults, endemic corruption, war declarations and government composition changes. These events pose both portfolio investment and foreign direct investment risks that can change the overall suitability of a destination for investment. Moreover, these events pose risks that can alter the way a foreign government must conduct its affairs as well. Macro political risks also affect the organizations operating in the nations and the result of macro level political risks are like confiscation, causing the seize of the businesses' property. Research has shown that macro-level indicators can be quantified and modelled like other types of risk. For example, Eurasia Group produces a political risk index which incorporates four distinct categories of sub-risk into a calculation of macro-level political stability. This Global Political Risk Index can be found in publications like The Economist. Other companies which offer publications on macro-level political risk include Economist Intelligence Unit, DaMina Advisors, iStrategic LLC, IHS Markit, Jane's and The PRS Group, Inc. DaMina Advisors is focused on frontier markets such as Africa. iStrategic LLC is focused on the Middle East and North Africa.

… excerpt ends here. Continue reading the full article.

Worked examples

Example 1 — a first encounter with Political risk

Start with the simplest possible case. Write down what Political risk claims or describes in one sentence, then invent the smallest concrete situation in which that sentence is true. In science, the smallest case is usually a single object, a single equation or a single measurement. Check that every symbol or term in your sentence has a meaning in that case.

Example 2 — changing one variable

Take the situation from Example 1 and change exactly one quantity: double it, halve it, or set it to zero. Predict what should happen to Political risk before you calculate. Comparing your prediction with the result is the fastest way to find out whether you understand the idea or only the words.

Example 3 — an exam-style question

Typical questions about Political risk ask you to (a) state it precisely, (b) apply it to given data, and (c) explain a limitation. Practise writing all three answers in under five minutes; the third part is what separates a full-mark answer from an average one.

Applications of Political risk

In research: Political risk appears in science research whenever the underlying quantities have to be modelled precisely. Papers usually cite it as a starting assumption and then explore where it breaks down.
In technology and industry: Engineering practice reuses Political risk in design rules, simulations and safety margins. Knowing the idea lets you read a specification sheet and understand why the numbers look the way they do.
In the classroom: Political risk is common in secondary-school and first-year university syllabi. It links to neighbouring topics Business terms, Financial economics, Risk management, so understanding it makes those chapters shorter.
In everyday life: Look for Political risk outside the textbook — in sport, cooking, traffic, electronics or the sky above you. An example you found yourself is remembered far longer than one you were given.

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How to study Political risk in 20 minutes

Read the reference excerpt below once, without taking notes.
Close the page and write down what Political risk means in your own words.
Compare your version with the excerpt and mark what you missed.
Work through the three examples above with pen and paper.
Explain Political risk out loud to somebody else — or to Teacher Smith in the lgStudy chat.

Frequently asked questions

What is Political risk in simple terms?

Why does Political risk matter?

Because it connects several science ideas at once: it gives you a definition you can apply, a quantity you can calculate, and a way to check whether a result is plausible.

How should I study Political risk?

Read the excerpt, restate it from memory, then work through the examples and applications listed on this page. The five-step study plan above takes about twenty minutes.

What does this page cover?

It gives you a compact reference excerpt plus original lgStudy explanations, examples, applications and study material on Political risk.