When an organization decides to engage in international financing activities, it takes on additional risk along with the opportunities. The main risks that are associated with businesses engaging in international finance include foreign exchange risk and political risk.
These challenges may sometimes make it difficult for companies to maintain constant and reliable revenue. In this article, we'll review the strategies companies can employ to reduce the impact of the risks they face from doing business internationally.
- The major international risks for businesses include foreign exchange and political risks.
- Foreign exchange risk is the risk of currency value fluctuations, usually related to an appreciation of the domestic currency relative to a foreign currency.
- Political risk happens when countries change policies that might negatively affect a business, such as trade barriers.
- Employing hedging strategies and purchasing political risk insurance are two ways companies can reduce the impact of international business risks.
Foreign Exchange Risk
Foreign exchange risk occurs when the value of an investment fluctuates due to changes in a currency's exchange rate. Foreign exchange risk is also known as FX risk, currency risk, and exchange-rate risk. 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. Foreign exchange risk typically affects businesses that export and/or import their products, services, and supplies.
Geopolitical risk, also known as 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.
Countries have implemented free-trade agreements, such as the North American Free Trade Agreement (NAFTA) and other similar measures, in an effort to reduce the number of trade barriers. However, not all of these measures are successful, and ongoing trade wars can disrupt an international company's business and market efficiency. Thus, the everyday differences in the laws of foreign countries continue to influence the profits and overall success of a company doing business transactions abroad.
Protection for International Businesses
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 risks by buying futures, currency forwards, or options on the currency market. The purpose of these hedges is to reduce the risk that price movements in the currency market will adversely affect the company's revenue and profits.
For example, importers and exporters will often use currency forwards to hedge against exchange rate fluctuations. They will enter into a currency forward contract with a bank or other financial institution. This binding over-the-counter (OTC) contract locks in the exchange rate for the purchase or sale of a specific currency on a future date.
Political Risk Insurance
Companies also may decide to acquire political risk insurance in order to protect their equity investments and loans from specific government actions. Multinational corporations will often outline in their 10-K annual filings with the U.S. Securities and Exchange Commission (SEC) the actions they take to mitigate against the political risk they face in foreign countries.
Political risk insurance helps these corporations continue to develop and grow their global businesses even in unpredictable or uncertain business conditions. Companies can purchase insurance that offers protection in the event of war, terrorism, labor disputes, supply shortages, and trade restrictions.
The Bottom Line
What a company must decide is whether the pros outweigh the cons when deciding to venture into the international market. With increased globalization, many companies see the benefits of expanding their reach beyond their domestic borders. The chance for increased revenue and the opportunity to bring their products and services to a larger audience plays an important role in their decision to focus on international markets.