My answer to this question is in accord with the one already provided by John. Generally, higher returns are associated with higher risks, as far as the guiding principle of 'finance' is concerned. However, this is not the end of the story. I agree with the statement that perceived risks overpower actual risks when investment decision is made. This is somewhat similar to 'inflation expectations' that may overpower actual inflation and guide policy makers implementing appropriate monetary policy. Obviously, an investment manager will concentrate on maximizing the 'net present value of shareholders wealth' and appear to be reluctant investing in a particular project if the perceived risks outweigh the actual risks associated with that project. Countries that suffer from political instability may face poor infllow of financial capital even if the actual return on investment apparently seems quite high. Here, the perceived risk adjusted returns on investment actually guides the investment decision.

Thank you Karim. I am writing regarding how such perceptions take root by applying a bit of psychology. Perhaps you may comment on my work after am done with the first draft.

Seems to me only common sense that perceived risk will discourage people from investing in economies where capital scarcity implies that rates of return would be high.

No doubt, there are many countries where perceived risk exceeds actual risk. There is a subtlety here, though. A favorable future outcome doesn't mean that the actual risk was low, or lower than the originally perceived risk.

For example, I now perceive it would be very risky for me to drive at 150km from my home into town. It is a winding road of 5km with a lot of traffic. If I do it anyhow, and have no accident, that doesn't change the fact that my perception of the risk was probably correct.

"Actual" risk in most circumstances is almost impossible to measure.

I am an attorney specializing in advising clients on infrastructure development and finance matters. I also teach law students, as well as foreign officials (many of whom are in emerging markets) on raising private capital. Perception of risk is a key issue when my clients are making an investment decision. Part of the evaluation includes a sovereign risk analysis as the success of a transaction is very much influenced by the willingness and ability of the country to support the project both at its inception and through the life of the deal,. Many infrastructure projects require a considerable amount of debt and equity capital, and it may take 15-20 years for the investor to repay the debt and obtain the expected return on the equity investment.

This analysis includes a number of issues, including the stability of the government, the economic conditions in the country, the history of the country and its citizens in supporting private investment in the country for infrastructure projects, and whether there is a favorable legal and regulatory climate. Additionally, it may take a number of years to develop projects, and if the perception is that it would take too much time or money to invest in a particular country, the investor may look at similar investments in other jurisdictions where the perception is that the development will be easier to manage. Finally, many of these projects use project financing as a means of raising debt, so even if the client is willing to invest in the project, the client considers whether lenders are willing to lend to the project and the conditions to providing the loans. The investors also evaluate the availability and cost of political risk insurance and the types of risks that the insurance covers as a way of mitigating these risks, again comparing this with availability and costs in other jurisdictions.

No doubt, you and many other people and firms carry out formidably good risk analyses. Even so, these can never be regarded as objective risk indicators. Such analyses may influence risk perceptions, as they presumably should. But risk perceptions are, almost by definition, subjective rather than objective.

John,

We shall assume the agents both external and internal in a given developing country are rational in their judgements (Robert Lucas' theory of rational expectations). This goes to show why there are cases where returns are very attractive but capital does not flow these markets simply because perceived risk is greater than what is actually on the ground. Take an example of Sub-Saharan Africa. Foreign Direct Investment flows are dismal compared to other continents due to this very fact. Investors will look at things like perception of "the degree of Failed State Status"(vulnerability to civil war outbreak and political instability); lack of functioning independent institutions (where irrational policy reversals are not difficult to come by such as nationalization of businesses or change of government leading to big changes in economic policy); perceived poor property rights enforcement, etc. If investors see Central African Republic, South Sudan, DR Congo; they may perceive neighboring Cameroon as not far from the high risk business environment yet this may not be true. I hope you can find an INDEX of this perceived risk measure (however subjective) to cater for this in your study.

Barnabas Kiiza

Makerere University

Note, here that by actual risk, i am referring to the risk metrics arrived at on the basis of some formal analysis. By no means do I refer to actual risk in the absolute sense. All risk assessments have a large subjectivity element. By percieved risk, on the other hand, I am refering to risk metrics based on gut feeling or intuition, or even following the crowd.

The question is: Is there a significant gap between these two metrics? and if so, does it warrant some level of intervention at government level? 

You may also want to incorporate the views of prof. Kalu Ojah that I am posting below.

The following are the views of Prof. Kalu Ojah on the question. He sent it to my mail inbox, thats why it does not appear under our discussion,

"Sovereign risk is essentially subsumed under the "investability" of a developing country. Therefore, should sovereign risk improve with several other important components of investability remaining sub par (e.g., institutions, macroeconomic policy stability, and financial development), that improvement is likely to have minimal effect in attracting foreign investment inflow."

John, I believe that you have essentially answered your own question. The psychology that underpins investors' reluctance to invest in asset classes of very high returns that come from a country perceived to have "too high" risks, would have most of the investors screen out very high risk-commensurate returns by instituting a maximum acceptable risk score. That is also probably what Lucas' work captures empirically.

prof Kalu Ojah. My only answer was the attached document....which to my surprise was a must read for the phD seminars at wbs. I rest my case for now. I am not convinced though

Hi,

You may be interested by this recent paper:

Sovereign Default Risk and the U.S. Equity Market.

By: Jeanneret, Alexandre. Journal of Financial & Quantitative Analysis. Feb2017, Vol. 52 Issue 1, p305-339. 35p. DOI: 10.1017/S0022109016000776.

Best regards

Thanks @Patrick Navatte