Organizations dealing in international finance are constantly faced with different kinds of risks and unless major strategies are taken to mitigate these risks, these organizations could easily become insolvent. Management of risk and anticipation of unexpected events gives an organization competitive advantage besides shielding it from the adverse effects arising from losses faced as a result of these risks. The major challenge facing organizations engaging in international financial activities is uncertainty which may make it impossible for them to maintain constant levels of income. Uncertainty is generally caused by two risk factors namely the fluctuations in the exchange and political factors (Yadav, 2008). Other risk examples include liquidity risk, reverse equity risk, and knock in risk and modeling risk (Madura, 2006). This paper will discuss the risk in currency exchange fluctuations, political risk and liquidity risk while offering solutions to these risks.
Foreign Exchange Risk
Domestic currency is subject to fluctuations from time to time resulting in depreciation or appreciation against a foreign currency. Depreciation of the domestic currency against the foreign currency brings in good returns to a company. Appreciation on the other hand decreases revenue and profits obtained by the company because profits made significantly reduce when they are converted into the local currency (Yadav, 2008). Fluctuations in the foreign exchange are usually caused by the changes in demand and supply of currency. Other factors such as political stability, economic welfare and changes in a country’s interest rates also influence foreign exchange (Das, 1993).
Exchange rates are quite volatile in nature and keep fluctuating from time to time depending on the situation in the market (Das, 1993). This makes it very difficult for companies to predict and guard themselves against the risks. However, organizations can shield themselves from such risks through purchase of futures and forwards. Futures refer to contracts formed to buy specific amounts of currency in the future at a price that is predetermined. Futures allow hedging of risks as the prices that are predetermined in the contract cannot be changed (Das, 1993). Forwards just like futures dictate the price at which an organization can buy a currency or sell it on a specified date in the future. Forwards are not transferable. The organizations should also do thorough comparative studies of the trends in foreign exchange before investing in any country. This ensures that risks likely to occur due to constant fluctuations are minimized.
When a government in which the country operates suddenly changes its policies on local and international investments, it may negatively affect the business. Such policies mostly have to do with tax revenue where the government may increase taxes due on profits through tariffs and quotas (Madura, 2006). Trade barriers may also be introduced by a country especially with an aim of protecting their local industries. In such a case, the organization may be forced to exit the market of the foreign country. Political unrest in a country is also a contributing factor to political risk. Wars and terrorism can cause economic decline in the country thus reducing the viability of investing in the particular country (Madura, 2006).
Mitigation of political risk is country specific and therefore the management should handle this risk depending on how the risk presents itself (Yadav, 2008). Every organization should come up with a strategy for political risk mitigation and the most common one is insurance. Organizations should insure themselves against political risks which will protect them from losses through unexpected government actions. Bargaining is often used by firms to get more favorable regulation by the host government. This has to be systematically organized and the aim is to convince the host government of the importance of survival for the organization and the nation as a whole. It may also involve agreement on the portion of the total amount of profits it will appropriate to the host country if it is allowed to establish its activities. Since political changes and disruptions may be unforeseeable, every organization must come up with strategies to deal with any crisis that may arise.
Liquidity risk is another major risk associated with the international finance activities. Liquidity risk may be described as a situation in which the organization cannot raise enough liquid assets required to satisfy its current needs (Das1993). Liquid assets are in the form of cash, bonds and securities that the organization uses to settle its debts. Shortage of liquid assets may render the company insolvent as it cannot satisfy its needs.
In management of liquidity risk, proper forecasting and formation of funding decisions and strategies is key (Das, 1993). The process involves calculation of the liquidity gap, identifying liquidity scenarios and coming up with measures to improve the liquidity gap. An organization that wants to minimize liquidity risks must have the capability to analyze and predict activities and situations that are likely to cause liquidity risk (Das, 1993). In order to reduce the possibilities of liquidity risk, managers in international organizations dealing with finance must conduct investigative studies to determine future liquidity needs and assess the surpluses available to the company; make informed funding decisions depending on the needs of the organization; come up with strategies to cover unforeseen liquidity risks for example through identifying alternative sources of funding; and finally improve on the capabilities of the organization to predict and respond to liquidity exposures should they arise. (Madura, 2006). Managers may choose to use management systems specifically designed to guide them in identifying and coping with liquidity risks. The procedures in these systems are generally similar or differ slightly from procedures given above. An example is the Liquidity Management System (LMS) by Aleri.
Every organization needs to come up with effective risk mitigation strategies to protect it from risks that it is likely to face. This is because such risks only serve to reduce the profitability of the firm thus impacting on its survival. Organizations dealing in international finance are constantly faced with different kinds of risks and unless major strategies are taken to mitigate these risks, these organizations could easily become insolvent.
Yadav, V. (2008). Risk in International Finance. London, UK: Routledge.
Madura, J. (2006). International financial management, 8th ed. Melbourne, Australia: Cengage Learning.
Das, D. K. (1993). International finance: contemporary issues. London, UK: Routledge.