Neil Woodford got it right

Friday 3 February 2017

A manager’s subjective perception is important for how firms manage political risk, argue Erasmo Giambona, John Graham, and Campbell Harvey in an upcoming paper.

Executive summary
• Political risk is a first-order risk more important than commodity price risk.
• Executives, most popular tool in managing increased political risk is to block all investment to a country they deem as risky.
• Personal risk aversion plays a major role in executives’ propensity to avoid investment in risky countries.

In a paper forthcoming in the Journal of International Business Studies and published in CFA UK’s magazine Professional Investor (PI), Erasmo Giambona, John Graham, and Campbell Harvey research the management of political risk. They address the impact of political risk on foreign direct investment.

To investigate the impact empirically, researchers have traditionally used objective measures of political risk, including 1) electoral uncertainty 2) conflict risks 3) social unrest 4) corruption 5) political instability 6) quality of the institutions in the host country 7) sovereign debt default risk and 8) market imperfections. Our paper addresses a classic research challenge put forth by Kobrin (1979): we can assess “what affects managers’ subjective perceptions” of political risk. To overcome the difficulty in measuring subjective preferences, we administer a psychometric test to evaluate the risk aversion of individual executives. We show that the personal risk aversion of executives is a significant factor explaining how their companies respond to political risk.

Behavioural models predict that it is not just the level of political risk that is important, it is also the individual manager’s sensitivity to that risk that dictates the corporate response to political risk. According to agency theory, corporate decisions are more likely to reflect the best interests of executives (rather than the best interests of shareholders) when managers’ interests are less aligned with those of stockholders. Thus, corporate risk management decisions will reflect an executive’s personal sensitivity to political risk in firms in which executives indicate that they are less concerned about the interest of stockholders and in firms managed by younger executives – who put their own career concerns ahead of the interests of shareholders.

Our data are gathered from a large scale survey of financial executives in North America, Europe, Asia, and other regions. The survey was conducted in the first quarter of 2010. Emails were obtained from four different sources: CFO Magazine, International Swaps and Derivatives Association (ISDA), the Global Association of Risk Professionals (GARP), and Duke University. We gathered 1,161 responses from non-financial industries (mining, manufacturing, transportation, utilities, communications, technology, retail, and healthcare) and the financial sector. The sample includes publicly listed firms and private firms.

We measure risk aversion with a psychometric test. We present a hypothetical case where the CFO must move to a new job because of, say, a medical condition. Given that the CFO currently earns $X, we ask them to choose between two new jobs: (1) 100% chance job pays $X for life; (2) 50% chance job pays $2X for life and 50% chance job pays $2/3 X for life. If the participant selects (1), we ask her to choose between the two following jobs: (3) 100% chance job pays $X for life; (4) 50% chance job pays $2X for life and 50% chance job pays $4/5 X for life. If the CFO selects (2), we ask her to choose between the two following jobs: (5) 100% chance job pays $X for life; (6) 50% chance job pays $2X for life and 50% chance job pays $1/2 X for life. We categorize the executives that choose the sequence (1) and (3) as risk averse.

Our results show that political risk is very important. The exhibit shows that the three most important risks are interest rate risk, foreign exchange risk, and credit risk. Political risk ranks fourth. Interestingly, financial executives consider political risk to be more important than either commodity or energy risk.

Given that our survey is anonymous, we also collect information on key demographic characteristics such as firm’s sales, profitability, and the age of the executive. We also rate the degree to which management is concerned in stockholder’s interest on a scale of 0 (the firm is not at all managed in the interest of stockholders) to 100 (firms is managed entirely in the interest of stockholders).

Our analysis indicates that firms in our global survey sample are comparable to those in standard archival databases such as Compustat Global. For example, we find that about 80% of firms are profitable in both our survey and Compustat Global. Leverage is also similar for the two groups (34% for the survey firms compared to 36% for the Compustat firms). The two samples are also roughly comparable in terms of firm’s size, dividend policies, and cash holdings.

Figure 1 Key Risks


Not surprisingly, we find a negative relation between political risk and FDI. However, more surprisingly, we find that nearly half of the executives in our sample say that they avoid investing in a risky country altogether as a way to manage political risk. That is, management does not try to hedge this political risk – or entertain smaller investments, they simply black ball the risky country. Consistent with a behavioural prediction, we find that companies with highly risk-averse financial executives are more likely to avoid investment in politically risky countries. That is, a manager’s subjective perception of political risk affects his or her firm’s decision to avoid investment in a politically risky country. Consistent with an agency theory prediction, we find that the effect of risk aversion on a firm’s decision to avoid investing in a politically risky country is stronger for executives who are less concerned about stockholder welfare, and is also stronger for younger executives.

While numerous studies have documented the effect of political risk on FDI using objective measures of such risk (conflicts, social unrest, electoral uncertainty, etc.), our paper documents that a manager’s subjective perception of political risk is also important for how firms manage political risk.



Erasmo Giambona
Erasmo Giambona is the Michael J. Falcone associate professor of finance and real estate and director of the James D. Kuhn Real Estate Center at Syracuse University’s Whitman School of Management. His research explores a variety of topics in finance and real estate and is published in leading journals. Currently, he serves as an associate editor of the Journal of Financial Intermediation.


John Graham
John Graham is the D. Richard Mead professor of finance at the Fuqua School of Business, Duke University and a research associate of the National Bureau of Economic Research. Graham has directed the Global Business Outlook CFO survey since 1997. His research focuses on taxes, capital structure, cash management, risk management, corporate culture, governance, financial reporting, and payout policy. He has worked as an economist at Virginia Power and is past president of the Western Finance Association, past co-editor of The Journal of Finance and president-elect of the Financial Management Association.

Campbell Harvey
Campbell Harvey is professor of finance at Duke University and an NBER Research Associate. He is president of the American Finance Association and has served as Editor of the Journal of Finance. Harvey is the investment strategy advisor to the Man Group, the world’s largest, publicly listed, hedge fund provider. He obtained his doctorate from the University of Chicago and won the 2016 and 2015 Best Paper Awards from The Journal of Portfolio Management for his research on distinguishing luck from skill. He has also received seven Graham and Dodd Awards/Scrolls for excellence in financial writing from the CFA Institute.