When an organization decides to engage in international financing activities, they also take on additional risk as well as opportunities. The main risks that are associated with businesses engaging in international finance include foreign exchange risk and political risk. These risks may sometimes make it difficult to maintain constant and reliable revenue.
Foreign exchange risk occurs when the value of investment fluctuates due to changes in a currency’s exchange rate. When a domestic currency appreciates against a foreign currency, profit or returns earned in the foreign country will decrease after being exchanged back to the domestic currency. Due to the somewhat volatile nature of the exchange rate, it can be quite difficult to protect against this kind of risk, which can harm sales and revenues.
For example, assume a U.S. car company receives a majority of its business in Japan. If the Japanese yen depreciates against the U.S. dollar, any yen-denominated profits the company receives from its Japanese operations will yield fewer U.S. dollars compared to before the yen\’s depreciation.
Political risk transpires when a country’s government unexpectedly changes its policies, which now negatively affect the foreign company. These policy changes can include such things as trade barriers, which serve to limit or prevent international trade. Some governments will request additional funds or tariffs in exchange for the right to export items into their country. Tariffs and
quotas are used to protect domestic producers from foreign competition. This also can have a huge effect on the profits of an organization because it either cuts revenues from the result of a tax on exports or restricts the amount of revenues that can be earned. Although the amount of trade barriers have diminished due to free-trade agreements and other similar measures, the everyday
differences in the laws of foreign countries can influence the profits and overall success of a company doing business transactions abroad.
In general, organizations engaging in international finance activities can experience much greater uncertainty in their revenues. An unsteady and unpredictable stream of revenue can make it hard to operate a business effectively. Despite these negative exposures, international business can open up opportunities for reduced resource costs and larger lucrative markets. There are also ways in
which a company can overcome some of these risk exposures.
For example, a business may attempt to hedge some of its foreign-exchange risk by buying futures, forwards or options on the currency market. They also may decide to acquire political risk insurance in order to protect their equity investments and loans from specific government actions. What a company must decide is whether the pros outweigh the cons when deciding to venture into the international market.
The main risks are;
• Transaction Costs
Likely the biggest barriers to investing in international markets are the transaction costs. Although we live in a relatively globalized and connected world, transactions costs can still vary greatly depending on which foreign market you are investing in. Brokerage commissions are almost always higher in international markets compared to domestic rates. In addition, on top of the higher brokerage commissions, there are frequently additional charges that are piled on top that are specific to the local market, which can include stamp duties, levies, taxes, clearing fees and exchange fees.
• Currency Risks
The next area of concern for retail investors is in the area of currency volatility. When investing directly in a foreign market (and not through ADRs), you have to exchange your domestic currency (USD for U.S. investors) into a foreign currency at the current exchange rate in order to purchase the foreign stock. If you then hold the foreign stock for a year and sell it, you will have to convert the foreign currency back into USD at the prevailing exchange rate one year later. It is the uncertainty of what the future exchange rate will be that scares many investors. Also, since a significant part of your foreign stock return will be affected by the currency return, investors
investing internationally should eliminate this risk.
The solution to mitigating this currency risk, as any financial professional will likely tell you, is to simply hedge your currency exposure. However, not many retail investors know how to hedge currency risk and which products to use. There are tools such as currency futures, options, and forwards that can be used to hedge this risk, but these instruments are usually too complex for a
normal investor. Alternatively, one tool to hedge currency exposure that may be more “user-friendly” for the average investor is the currency ETF. This is due to their good liquidity, accessibility and relative simplicity. (If you want to learn the mechanics of hedging with a currency ETF, see Hedge Against Exchange Rate Risk With Currency ETFs.)
• Liquidity Risks
Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. Liquidity risk is the risk of not being able to sell your stock quickly enough once a sell order is entered. In the previous discussion on currency risk we described how currency risks can be eliminated, however there is typically no way for the average investor to protect themselves from liquidity risk. Therefore, investors should pay particular attention to foreign investments that are, or can become, illiquid by the time they want to close their position.
Further, there are some common ways to evaluate the liquidity of an asset before purchase. One method is to simply observe the bid-ask spread of the asset over time. Illiquid assets will have wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity. Altogether, these basic measures can help you create a picture of an asset’s liquidity.
• Country Risk
The factors usually associated with this type of risk are the political and economic stability of a country, exchange controls, if any, and the country’s penchant for protectionism of domestic industry at short notice. All these factors will determine whether the country can and will honor their payment commitments-in time. For example, from many a first world country point of view, Sri Lanka is seen as a reasonable short term risk, (i.e., an export exposure up to two years is considered in order, provided the Sri Lankan importer can produce a documentary credit, preferably confirmed by a “first class” bank.) This is because Sri Lanka has liberalized exchange
control, has no history of default on foreign debt commitments and has a reasonably robust economy. What holds the country back from being seen as a “more comfortable” level of risk is the political problems caused by the separatist issue.
Most banks have specialized units dealing with country risk and they control the level of exposure that bank will assume for each country. This system of policing is vital where balancing the stability of the institution against the greater profitability of transactions with higher risk areas. However, there is often a lot of friction between commercial bankers and these units where the former feels that the latter is too strict at times and business considerations are overlooked.
• Foreign Exchange Risk
Payments and receipts in foreign currency are an everyday occurrence in international trade and the trader is always at the mercy of exchange rate fluctuations due to various economic, political and even purely speculative reasons. The astronomical volume of the global foreign exchange market leaves the importer/exporter with no control and an adverse movement in the transaction currency vis-a-vis the local currency can wipe out the entire profit and more of the deal. It is vital that traders forge links with foreign exchange trading rooms in banks as then they will be able to stay abreast of the dynamic market and, more importantly, enter into forward foreign exchange contracts to protect their profit margin. Surprisingly, many lending officers in banks consider the dealing room of a bank as a place of mystery and leave their customer to discuss any exchange rate issues with the dealer. This should not be the case and lenders must make efforts to gain at least a basic understanding of the workings and trends in the market.
• Bank Risk
We do not need a rocket scientist to tell us that the world is full of banks of varying degrees of stability and strength and indeed the business pages of major magazines and newspapers are filled with articles on bank performance and bank collapse. When financing an importer or exporter, a bank often looks to the security of a backing document issued by another bank, be it a guarantee or a documentary credit. It is important to realize that the documentary credit issued by Bank A may not be as secure as that issued by Bank B, due to Bank A.
- having a history or delaying or actually reneging on payment.
- having a habit of rejecting documents citing trivial discrepancies;
- being domiciled in a country notorious for foreign exchange restrictions and moratoriums; and
- being domiciled in a country classified as high risk.
Dealing with bank risk is quite complicated and can be a sensitive issue most of the time, even more than country risk. Again, many banks leave this problem to a specialized unit and seek their guidance from time to time. In fact, many international banks produce and distribute instructions for their branches, setting limits for the various institutions they traditionally deal with. Anything outside such parameters has to be referred to this specialized unit for clearance.
A contribution to the business decision is also required from the management of the branch and if they feel that the branch can maintain recourse to a valued customer, then there is some flexibility to deal with the higher risk bank.
To cover the various aspects of maritime and indeed any other type of trade fraud requires volumes of paper. There are various types of fraud like documentary fraud, counterpart fraud, insurance scams, cargo theft, scuttling and piracy. Unfortunately, there are some countries which are renowned for harbouring fraudsters. The golden rule is “if the deal looks too good to be true, it probably is” and one should be cautious when dealing with transactions which are much larger in value than the norm. Forged documentary credits are always in circulation and fortunately, an experienced trade services officer can detect a dud credit more often than not. If goods are released against an undertaking by the importer to pay in the future – usually by accepting a draft – then the exporter/financing bank loses control over the goods and this method of release termed D/A (documents against acceptance) is more risky than D/P.