Meaning and definition of economic risk
Generally speaking, economic risk can be described as the likelihood that an investment will be affected by macroeconomic conditions such as government regulation, exchange rates, or political stability, most commonly one in a foreign country. In other words, while financing a project, the risk that the output of the project will not produce adequate revenues for covering operating costs and repaying the debt obligations.
Economic risk is, however, a nebulous term with various definitions. In a nutshell, economic risk refers to the risk that a venture will be economically unsustainable, due to various reasons vitiating from an alteration in economic trends to fraudulent activities which ruin a project’s outcome. Before starting with the projects, it is important to consider economic risk for determining the likelihood of potential risks being outweighed by the benefits.
Example of economic risk
The economic risk can be looked upon in a variety of ways, with a wide range of modeling systems. In a simple example, let us presume a planned housing development. In this case, the economic risk is that the gains from the development will not cover the development costs, leaving the developer in debt. This can take place due to downturns in the real estate market, lack of interest in the housing, unexpected cost overruns, and various other factors.
Why economic risk matters
Economic risk is one of the reasons for international investing carrying higher risk as compared to domestic investing. Bondholders and shareholders generally put up with the risk undertaken by international companies. Investors dealing in sale and purchase foreign government bonds are also exposed.
Moreover, economic risk can also provide additional opportunities for investors. For example, foreign bonds allow investors to involve themselves circuitously in the foreign exchange markets as well as the interest rate environments of various countries. However, the foreign regulatory authorities can impose different requirements on the sizes, types, timing, credit quality, disclosures of bonds, and underwriting of bonds issued in their countries.
Economic risk can be, however, reduced by opting for international mutual funds for they proffer instantaneous diversification, time and again investing in various countries, currencies, instruments, or international industries.