SUMMARY NOTES
BY DR.STEPHEN
TOPIC 4: RISK AND INTERNATIONAL TRADE AND
FINANCE
Objectives:
i) Highlight types of risks in international finance
ii) Discuss currency exposures
In addition to normal business and financial risk, companies face extra risks
connected with trading and investing overseas. These risks can be separated into
political risk and foreign exchange risk.
Political or Country Risk
Political risk (also known as country risk) includes the problems of managing
subsidiaries geographically separated and based in areas with different cultures and
traditions, and political or economic measures taken by the host government
affecting the activities of the subsidiary.
Whilst a host country will wish to encourage the growth of industry and commerce
within its borders, and offer incentives to attract overseas investment (such as
grants), it may also be suspicious of outside investment and the possibility of
exploitation of itself and its population. The host government may restrict the
foreign companies' activities to prevent exploitation or for other political and
1
,financial reasons. Such restrictions may range from import quotas and tariffs
limiting the amount of goods the firm can either physically or financially viably
import, to appropriation of the company's assets with or without paying
compensation. Other measures include restrictions on the purchasing of companies,
especially in sensitive areas such as defense and the utilities - such restrictions
could be an outright ban, an insistence on joint ventures or a required minimum
level of local shareholders. In order to prevent the "dumping" of goods banned
elsewhere (e.g. for safety reasons) a host government may legislate as to minimum
levels of quality and safety required for all goods produced or imported by foreign
companies.
Host governments, particularly in developing and underdeveloped countries, may
be concerned about maintaining foreign currency reserves and preventing a
devaluation of their national currency. In order to do this they may impose
exchange controls. This is generally done by restricting the supply of foreign
currencies - thus limiting the levels of imports and preventing the repatriation of
profits by MNCs by restricting payments abroad to certain transactions. This latter
method often causes MNCs to have funds tied up unproductively in overseas
countries.
Foreign Exchange or Currency Risk
Exchange rate risk applies in any situation where companies are involved in
international trade. It arises from the potential for exchange rates to move
adversely and, thereby, to affect the value of transactions or assets denominated in
a foreign currency.
2
, There are three main types of exchange rate risk to which those dealing overseas
(importers, exporters, those with overseas subsidiaries or parents, and those
investing in overseas markets) may be exposed.
a) Transaction exposure
This occurs when trade is denominated in foreign currency terms and there is a
time delay between contracting to make the transaction and its monetary
settlement. The risk is that movements in the exchange rate, during the intervening
period, will increase the amount paid for the goods/services purchased or decrease
the value received for goods/services supplied.
(b) Translation exposure
This arises where balance sheet assets and liabilities are denominated in different
currencies. The risk is that adverse changes in exchange rates will affect their value
on conversion into the base currency.
Any gains or losses in the book values of monetary assets and liabilities during the
process of consolidation are recorded in the profit and loss account. Since only
book values are affected and these do not represent actual cash flows, there is a
tendency to disregard the importance of translation exposure. This is, though, a
false assumption since losses occurring through translation will be reflected in the
value of the firm, affecting the share price and hence, shareholders' wealth and
perceptions among investors of the firm's financial health.
(c) Economic exposure
This refers to changes in the present value of a company's future operating cash
flows, discounted at the appropriate discount rate, as a result of exchange rate
movements.
3
BY DR.STEPHEN
TOPIC 4: RISK AND INTERNATIONAL TRADE AND
FINANCE
Objectives:
i) Highlight types of risks in international finance
ii) Discuss currency exposures
In addition to normal business and financial risk, companies face extra risks
connected with trading and investing overseas. These risks can be separated into
political risk and foreign exchange risk.
Political or Country Risk
Political risk (also known as country risk) includes the problems of managing
subsidiaries geographically separated and based in areas with different cultures and
traditions, and political or economic measures taken by the host government
affecting the activities of the subsidiary.
Whilst a host country will wish to encourage the growth of industry and commerce
within its borders, and offer incentives to attract overseas investment (such as
grants), it may also be suspicious of outside investment and the possibility of
exploitation of itself and its population. The host government may restrict the
foreign companies' activities to prevent exploitation or for other political and
1
,financial reasons. Such restrictions may range from import quotas and tariffs
limiting the amount of goods the firm can either physically or financially viably
import, to appropriation of the company's assets with or without paying
compensation. Other measures include restrictions on the purchasing of companies,
especially in sensitive areas such as defense and the utilities - such restrictions
could be an outright ban, an insistence on joint ventures or a required minimum
level of local shareholders. In order to prevent the "dumping" of goods banned
elsewhere (e.g. for safety reasons) a host government may legislate as to minimum
levels of quality and safety required for all goods produced or imported by foreign
companies.
Host governments, particularly in developing and underdeveloped countries, may
be concerned about maintaining foreign currency reserves and preventing a
devaluation of their national currency. In order to do this they may impose
exchange controls. This is generally done by restricting the supply of foreign
currencies - thus limiting the levels of imports and preventing the repatriation of
profits by MNCs by restricting payments abroad to certain transactions. This latter
method often causes MNCs to have funds tied up unproductively in overseas
countries.
Foreign Exchange or Currency Risk
Exchange rate risk applies in any situation where companies are involved in
international trade. It arises from the potential for exchange rates to move
adversely and, thereby, to affect the value of transactions or assets denominated in
a foreign currency.
2
, There are three main types of exchange rate risk to which those dealing overseas
(importers, exporters, those with overseas subsidiaries or parents, and those
investing in overseas markets) may be exposed.
a) Transaction exposure
This occurs when trade is denominated in foreign currency terms and there is a
time delay between contracting to make the transaction and its monetary
settlement. The risk is that movements in the exchange rate, during the intervening
period, will increase the amount paid for the goods/services purchased or decrease
the value received for goods/services supplied.
(b) Translation exposure
This arises where balance sheet assets and liabilities are denominated in different
currencies. The risk is that adverse changes in exchange rates will affect their value
on conversion into the base currency.
Any gains or losses in the book values of monetary assets and liabilities during the
process of consolidation are recorded in the profit and loss account. Since only
book values are affected and these do not represent actual cash flows, there is a
tendency to disregard the importance of translation exposure. This is, though, a
false assumption since losses occurring through translation will be reflected in the
value of the firm, affecting the share price and hence, shareholders' wealth and
perceptions among investors of the firm's financial health.
(c) Economic exposure
This refers to changes in the present value of a company's future operating cash
flows, discounted at the appropriate discount rate, as a result of exchange rate
movements.
3
