What is Economic Risk?
Economic risk is the chance that macroeconomic conditions like exchange rates, government regulation, or political stability will affect an investment, usually one in a foreign country.
How Does Economic Risk Work?
For example, let's assume American Company XYZ invests $1,000,000 in a manufacturing plant in the Congo. Aside from the business risk associated with making the plant profitable, Company XYZ is exposed to economic risk.
The political environment could shift quickly, perhaps prompting the Congolese government to seize the plant or significantly change laws that affect Company XYZ's ability to operate the plant.
Why Does Economic Risk Matter?
Economic risk is one reason international investing carries more risk than domestic investing. Shareholders and bondholders often the economic risk undertaken by international companies like Company XYZ. Investors who purchase and sell foreign government bonds are also exposed.
Economic risk may also add opportunity for investors. Foreign bonds, for example, allow investors to participate indirectly in the foreign exchange markets and the interest rate environments of different countries. But the foreign regulatory authorities may impose different requirements on the types, sizes, timing, credit quality, disclosures, and underwriting of bonds issued in their countries.
Economic risk can be mitigated by opting for international mutual funds because they provide instant diversification, often investing in a variety of countries, instruments, currencies, or international industries.