Thanks to the advancements in technology, communication tools and transportation have improved tremendously to the benefit of international business. The blurry line between foreign and domestic is disappearing in the age of globalization. Nevertheless, making investments in some foreign markets is an acceptance of additional risks. While opportunities also abound, the risks abroad can be greater than what can occur at home.
Identifying and assessing these risks is essential to dealing with them in a productive manner. Basically, this involves a two-step process to determine the risk first and follow appropriate actions or inactions to resolve it. Business investors must quantify potential losses and take the necessary steps based on objectives and risk tolerance.
Risk management solutions provide the right balance between opportunities for increasing revenues in a foreign country. International business is good for business, but greater potential lies in recognizing risks and implementing good practices to overcome long-term negative effects. With greater understanding comes an appreciation for the dangers that inevitably accompany greater growth overseas.
Typically, the culture of a company dictates how people behave and strategize. Rules differ greatly from one country to the next. Communicating effectively between different business cultures requires an understanding and acceptance of differences.
This extends beyond the obvious barriers of groups speaking their native language. Behaviors, gestures and business practices that differ among countries does not automatically equate to failure. However, not taking time to understand cultural practices will affect how business is conducted. Grasping cultural differences is the foundation for managing risks and staying ahead of fluctuating circumstances that can hinder business overseas.
Exposure to unanticipated currency exchange rate fluctuations poses financial risks for international businesses. This event between two currencies can occur over time and cause gains or losses. Risks associated with currency exchange rates include exposure of transactions, economic and translation.
Transaction
A transaction exposure occurs when a business has contractual cash flows of receivables and payables that are subject to unanticipated changes in rates. This is particularly true when the contract is denominated in the foreign currency rather than the currency rate of the business’s native land.
To illustrate, an American business could borrow 100 million in Japanese Yen for a one year term with a three percent effective annual interest rate. Upon receiving the loan, the business converts the 100 million Yen into $1 million at the current exchange rate, which is $1 for every 100 Yen. The following year, the American business will need 103 million Yen to repay the loan. If at that time the exchange rate between the Dollar and Yen has decreased to $1 for every 90 Yen, the business would need to pay approximately $1,144,444 to buy the 103 million Yen.
Economic
Economic exposure, or operating exposure, causes risks to the market value of a business changing when exchange rates fluctuate unexpectedly. When this occurs, the cost of producing goods and services – along with sale prices – can be affected. As a result, profits could rise or fall with the currency exchange rate.
Translation
Movements in the exchange rate affect the financial reporting of a business, which leads to translation exposure. Generally, this type of risk involves revaluation of foreign assets held in foreign currency due to variances in foreign currency exchange rates. Revaluation of this kind creates a loss or gain in exchange rates for a business.
Any international business that has the option to select a billing and pricing currency should use its national currency, which can help to eliminate exchange risks. However, not all businesses have this option available when expanding to foreign countries. In these cases, a business could add a margin buffer to invoices quoted in foreign currency.
Another option is to have a contract of shared risk when significant fluctuations occur in foreign exchange rates. Typically, the contract would cover fluctuations that occur from the date an invoice is generated to the time when payment is made.
International businesses may also have other financial instruments such as forwards, futures and options at their disposal to hedge against risks. A foreign exchange forward contract would have the transaction amount, delivery date and exchange rate agreed upon in advance. This is a good way to lock in an exchange rate since no money is exchanged until the settlement date.
Similar to a foreign exchange forward, the currency future also determines a delivery date, but will include the contract size and a fixed foreign exchange rate. One difference between the two is daily changes to the contract price. Only one transfer occurs at the maturity date in forwards; currency futures are not hit with a default risk, which could happen in forwards.
Currency option involves a contract that gives the holder of the contract rights to buy or sell currency any time before the contract expires. The advantage of using a currency option contract is the holder is not obligated to buy foreign currency at the agreed price when the foreign exchange rate on the market is lower. However, the cost to buy a currency option contract is higher than what it costs for forwards or futures.
Before moving operations into a foreign country, a business should assess the political stability of that country. In addition, the general attitude towards foreign investments in the country should also be considered. Changes that may occur within the government or regulatory environment could have a direct impact on business decisions. Terrorism, acts of war and trade barriers can put foreign business investments at risk. While these are extreme examples, careful consideration is required when deciding if the business opportunity is worth the risk.
Along with the political climate, a business should determine current economic conditions of the country. This includes determining how future development could impact the foreign country’s purchasing power, GDP, inflation rate and unemployment rate. Economic risks are also associated with the financial condition of a foreign country and whether the country can repay its debts.
Armed with the analysis of this information, business investors can make predictions on how much loss might take place.
The security environment in foreign countries is equally important to evaluating and understanding. In addition to political unrest, these types of conditions include crime, and kidnap and ransom risks. Employees of businesses operating in foreign lands should be informed of any changes that pose risks to their security. The U.S. State Department updates its website when potential risks are on the radar. However, that is not a substitute for regular briefings and security updates between businesses and employees.
Health risk profiles of foreign countries are a prerequisite to traveling for business purposes, as well as setting up operations. The Centers for Disease Control and Prevention offers advice on all the recommended prophylactic medications and vaccinations that employees should receive before entering a country. Supplemental information is also available from medical websites, travel medical clinics and travel insurance providers.
Once employees are in a foreign country, it is the business’s responsibility to make sure they can access health and medical support in an emergency. Assistance for infrequent travel to foreign developed countries is usually available through a travel medical insurance plan. However, travel to underdeveloped countries may require customized solutions from a medical assistance provider.
Conducting international business requires a proactive stance on risk management techniques. The diversity of issues and uncertain variables can quickly change the dynamics of business success or failure. More risks are prevalent in international markets, but there are also potential gains.
With due diligence before making an investment, businesses can understand the political, financial, economic and social climates that have a direct impact on operations. Knowing how to manage risks associated with international business can lead to profits around the world.
