What is Jurisdiction Risk?
Jurisdiction risk is the risk of doing business in another country.
How Does Jurisdiction Risk Work?
Let's assume you are considering purchasing a bond issued by a Canadian company or a bond issued by a Nigerian company. Both companies intend to use the funds for similar projects. Which bond is safer? That depends in part on your assessment of jurisdiction risk.
Political and economic instability are two of the biggest factors in jurisdiction risk, so the question of jurisdiction risk is at least partially a matter of comparing these factors for Canada and Nigeria. Analysts also scrutinize differences in tax systems, the influence of certain political parties, evidence of corruption or terrorism, inflation rates, education systems, demographics and a wide variety of other factors to determine and predict sources of instability. They do this because these elements can change the relative value of the currencies, the chances that a government will seize the company's assets or that war will break out.
The Financial Action Task Force monitors and lists countries that pose certain jurisdiction risks.
Why Does Jurisdiction Risk Matter?
Jurisdiction risk creates volatility. In turn, investors demand higher returns as compensation for this added risk. As you can imagine, Canada seems to have less jurisdiction risk than Nigeria, so the Canadian bonds will return less than the Nigerian bonds will, assuming neither defaults. The presence and degree of jurisdiction risk makes it more expensive for many emerging companies in struggling countries to borrow money, and there is considerable controversy about the effects of this.
Jurisdiction risk can have a profound effect on financial markets. The powerhouse economy of the United States has long given it the lowest level of jurisdiction risk in the world, for example. But when a country's government defaults on its securities -- or even comes close to defaulting -- often investors around the world sell their investments in that country or that country's currency, which affect that country's economy, the economies of neighboring countries and those of its big trading partners.