(1) Strategic Risk

(2) Operational Risk

(3) Political Risk
(4) Country Risk
(5) Technological Risk
(6) Environmental Risk
(7) Economic Risk
(8) Financial Risk
(9) Terrorism Risk

Strategic Risk: The ability of a firm to make a strategic decision in order to respond to the forces
that are a source of risk. These forces also impact the competiveness of a firm. Porter defines
them as: threat of new entrants in the industry, threat of substitute goods and services, intensity
of competition within the industry, bargaining power of suppliers, and bargaining power of
consumers.

Operational Risk: This is caused by the assets and financial capital that aid in the day-to-day
business operations. The breakdown of machineries, supply and demand of the resources and
products, shortfall of the goods and services, lack of perfect logistic and inventory will lead to
inefficiency of production. By controlling costs, unnecessary waste will be reduced, and the
process improvement may enhance the lead-time, reduce variance and contribute to efficiency in
globalization.

Political Risk: The political actions and instability may make it difficult for companies to operate
efficiently in these countries due to negative publicity and impact created by individuals in the
top government. A firm cannot effectively operate to its full capacity in order to maximize profit
in such an unstable country's political turbulence. A new and hostile government may replace the
friendly one, and hence expropriate foreign assets.

Country Risk: The culture or the instability of a country may create risks that may make it
difficult for multinational companies to operate safely, effectively, and efficiently. Some of the
country risks come from the governments' policies, economic conditions, security factors, and
political conditions. Solving one of these problems without all of the problems (aggregate)
together will not be enough in mitigating the country risk.

Technological Risk: Lack of security in electronic transactions, the cost of developing new
technology, and the fact that these new technology may fail, and when all of these are coupled
with the outdated existing technology, the result may create a dangerous effect in doing business
in the international arena.

Environmental Risk: Air, water, and environmental pollution may affect the health of the
citizens, and lead to public outcry of the citizens. These problems may also lead to damaging the
reputation of the companies that do business in that area.
Economic Risk: This comes from the inability of a country to meet its financial obligations. The
changing of foreign-investment or/and domestic fiscal or monetary policies. The effect of
exchange-rate and interest rate make it difficult to conduct international business.

Financial Risk: This area is affected by the currency exchange rate, government flexibility in
allowing the firms to repatriate profits or funds outside the country. The devaluation and
inflation will also impact the firm's ability to operate at an efficient capacity and still be stable.
Most countries make it difficult for foreign firms to repatriate funds thus forcing these firms to
invest its funds at a less optimal level. Sometimes, firms' assets are confiscated and that
contributes to financial losses.

Terrorism Risk: These are attacks that may stem from lack of hope; confidence; differences in
culture and religious philosophy, and/or merely hate of companies by citizens of host countries.
It leads to potential hostile attitudes, sabotage of foreign companies and/or kidnapping of the
employers and employees. Such frustrating situations make it difficult to operate in these
countries.

Although the benefits in international business exceed the risks, firms should take a risk
assessment of each country and to also include intellectual property, red tape and corruption,
human resource restrictions, and ownership restrictions in the analysis, in order to consider all
risks involved before venturing into any of the countries.

Risks in international trade can be divided under several types, such as,

Economic risks

 Risk of concession in economic control

 Risk of insolvency of the buyer
 Risk of non-acceptance
 Risk of protracted default i.e. the failure of the buyer to pay off the due amount after six
months of the due date
 Risk of Exchange rate

Political risks
 

 Risk of non- renewal of import and exports licenses

 Risks due to war
 Risk of the imposition of an import ban after the delivery of the goods
 Surrendering of political sovereignty
 Buyer Country risks
 

 Changes in the policies of the government

 Exchange control regulations
 Lack of foreign currency
 Trade embargoes

Commercial risk
 

 A bank's lack of ability to honor its responsibilities

 A buyer's failure pertaining to payment due to financial limitations
 A seller's inability to provide the required quantity or quality of goods

Others Risks
 

 Cultural differences e.g., some cultures consider the payment of an incentive to help
trading is absolutely lawful
 Lack of knowledge of overseas markets
 Language barriers
 Inclination to corrupt business associates
 Legal protection for breach of contract or non-payment is low
 Effects of unpredictable business environment and fluctuating exchange rates
 Sovereign risk - the ability of the government of a country to pay off its

 Natural risk – due to the various kinds natural catastrophes, which cannot be controlled

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.

Expropriation
 The most intrusive and feared form of legal risk in international investment is direct or indirect
expropriation of assets or property. This usually occurs when a government seizes property for its own
use or distribution to private domestic investors. The expropriation of oil and other mineral wealth by
dictators is a classic example of direct expropriation. Indirect expropriation can happen gradually as the
property rights of foreign investors are eroded in a variety of ways.

Legal Protections and Remedies

 Another major risk in international investment is the lack of adequate legal protections and remedies.
In many cases, there might not be a clear legal authority with the jurisdiction to correct any injustices
like expropriation. In other cases, the authority may lack the ability to formulate or enforce a suitable
remedy. The censorship of Google search results in China is a good example of a situation where there is
no clear recourse to legal remedy. Even when such protections are available they can be costly or time
consuming.
Treaties and Agreements
 A very explicitly legal risk to international investment is changes in treaties or agreements between
nations that could adversely impact your investments or business. For example, carbon reduction
treaties could directly impact the cost of a wide variety of business with relatively little input from the
businesses themselves. Such agreements become the law of the land in the U.S. and there is very little
chance of them being overturned by domestic or international courts.

Transparency and Regulation

 Another more granular legal risk attending international investment is the direct regulation of
corporate disclosures and overall transparency. Domestic U.S. businesses are subject to a plethora of
SEC disclosure requirements and are relatively transparent about their finances and operations.
Businesses in other countries are often under no such obligations, making investment inherently riskier
if adequate and reliable information cannot be obtained. There is also the possibility that foreign
regulatory bodies will prosecute and obtain adverse rulings that would not occur in the U.S., as
happened when antitrust regulators in the European Union found Intel's practices to be anti-competitive
and levied a fine of €1.06 billion ($1.44 billion)

Customer Risk

Customer risk investigates the identity of customers in the host country. By assessing customer
risk, the firm inspects if customers are legally established businesses in the host country or
importers, if the firms’ exports are compatible with the customers’ business profile, what are the
customers’ credit limits and period, their trading history, their paying credibility and solvency.

Credit Risk

Credit risk is associated with the customers’ solvency but also the firm’s business cycle. To
assess this type of risk, the firm needs to take into consideration the amount of credit outstanding
- both overseas and domestic - in the trading accounts, the impact of a customer’s financial
pitfall of the firm, the maximum amount of credit which should not be exceeded, and most
importantly how to finance the offered credit period. Having sufficient cash to allow offering
credit terms in export sales is a substantial part of the firm’s business circle.

Foreign Exchange Risk

Foreign exchange risk is associated with dealing in the host country in more than one currency.
This type of international trade risk typically affects export and import businesses as they are
exposed to fluctuations in the foreign exchange markets. If money

is converted to another currency in order to make a payment to the host country, then any
changes in the currency exchange rate will cause that money’s value to either decrease or
increase when the payment is being made and currency is converted back into the original
currency.

Political Risk
Political risk measures the variability in the value of the firm, caused by uncertainty about
political changes. In the era of globalization, host countries may be facing rigid legislative,
judiciary and governmental institutions, unfavourable to international operations from foreign
firms. Moreover, dictatorships, bribery, corruption and unstable governments are, in many cases,
substantial reasons for assessing the political risk involved in a firm’s launching onto a foreign
country.

Moreover, political risk in the host country is often not correlated with global economic
conditions thus eliminating the possibility of global intervention. Ideally, the firm’s cash flows
should be invested in different host countries. Yet, in the absence of global intervention, the
firm's cash flows do not allow risk diversification.

Country Risk

Closely related to the political risk factor, country risk is affected by the legislative, judiciary and
governmental institutions, the current account deficit, the level of national debt, the foreign
exchange reserves, the internal or external threats to the host country and the imposition of tariff
or other quotas, and import or export restrictions. It may also include the risk of physical
climactic catastrophes such as flood, drought, and earthquake.

Beyond doubt, doing business in a foreign country entails major business risks. The key is to
assess these risks properly in order to eliminate the failure factor in the firm’s global operations,
but also to be prepared to anticipate the cost of such a failure.

Description of Foreign Exchange Risk

In simple word FOREX risk is the variability in the profit due to change in foreign exchange
rate. Suppose the company is exporting goods to foreign company then it gets the payment after
month or so then change in exchange rate may effect in the inflows of the fund. If rupee value
depreciated he may loose some money. Similarly if rupees value appreciated against foreign
currency then it may gain more rupees. Hence there is risk involved in it.

Classification of Foreign Exchange Risk

 Position Risk
 Gap or Maturity or Mismatch Risk
 Translation Risk
 Operational Risk
 Credit Risk

1. Position Risk

The exchange risk on the net open Forex position is called the position risk. The position can be
a long/overbought position or it could be a short/oversold position. The excess of foreign
currency assets over liabilities is called a net long position whereas the excess of foreign
currency liabilities over assets is called a net short position. Since all purchases and sales are at a
rate, the net position too is at a net/average rate. Any adverse movement in market rates would
result in a loss on the net currency position.

For example, where a net long position is in a currency whose value is depreciating, the
conversion of the currency will result in a lower amount of the corresponding currency resulting
in a loss, whereas a net long position in an appreciating currency would result in a profit. Given
the volatility in Forex markets and external factors that affect FX rates, it is prudent to have
controls and limits that can minimize losses and ensure a reasonable profit.

The most popular controls/limits on open position risks are:

 Daylight Limit : Refers to the maximum net open position that can be built up a trader
during the course of the working day. This limit is set currency-wise and the overall
position of all currencies as well.
 Overnight Limit : Refers to the net open position that a trader can leave overnight – to
be carried forward for the next working day. This limit too is set currency-wise and the
overall overnight limit for all currencies. Generally, overnight limits are about 15% of the
daylight limits.

2. Mismatch Risk/Gap Risk

Where a foreign currency is bought and sold for different value dates, it creates no net position
i.e. there is no FX risk. But due to the different value dates involved there is a “mismatch” i.e.
the purchase/sale dates do not match. These mismatches, or gaps as they are often called, result
in an uneven cash flow. If the forward rates move adversely, such mismatches would result in
losses. Mismatches expose one to risks of exchange losses that arise out of adverse movement in
the forward points and therefore, controls need to be initiated.

The limits on Gap risks are:

 Individual Gap Limit : This determines the maximum mismatch for any calendar
month; currency-wise.
 Aggregate Gap Limit : Is the limit fixed for all gaps, for a currency, irrespective of their
being long or short. This is worked out by adding the absolute values of all overbought
and all oversold positions for the various months, i.e. the total of the individual gaps,
ignoring the signs. This limit, too, is fixed currency-wise.
 Total Aggregate Gap Limit : Is the limit fixed for all aggregate gap limits in all
currencies.

3. Translation Risk

Translation risk refers to the risk of adverse rate movement on foreign currency assets and
liabilities funded out of domestic currency.
There cannot be a limit on translation risk but it can be managed by:

1. Funding of Foreign Currency Assets/Liabilities through money markets i.e. borrowing or

lending of foreign currencies
2. Funding through FX swaps
3. Hedging the risk by means of Currency Options
4. Funding through Multi Currency Interest Race Swaps

4. Operational Risk

The operational risks refer to risks associated with systems, procedures, frauds and human errors.
It is necessary to recognize these risks and put adequate controls in place, in advance. It is
important to remember that in most of these cases corrective action needs to be taken post-event
too. The following areas need to be addressed and controls need to be initiated.

 Segregation of trading and accounting functions : The execution of deals is a function

quite distinct from the dealing function. The two have to be kept separate to ensure a
proper check on trading activities, to ensure all deals are accounted for, that no positions
are hidden and no delay occurs.
 Follow-up and Confirmation: Quite often deals are transacted over the phone directly
or through brokers. Every oral deal has to be followed up immediately by written
confirmations; both by the dealing departments and by back-office or support staff. This
would ensure that errors are detected and rectified immediately.
 Settlement of funds: Timely settlement of funds is necessary not only to avoid delayed
payment interest penalty but also to avoid embarrassment and loss of credibility.
 Overdue contracts: Care should be taken to monitor outstanding contracts and to ensure
proper settlements. This will avoid unnecessary swap costs, excessive credit balances and
overdrawn Nostro accounts.
 Float transactions: Often retail departments and other areas are authorised to create
exposures. Proper measures should be taken to make sure that such departments and areas
inform the authorised persons/departments of these exposures, in time. A proper system
of maximum amount trading authorities should be installed. Any amount in excess of
such maximum should be transacted only after proper approvals and rate.

5. Credit Risk

Credit risk refers to risks dealing with counter parties. The credit is contingent upon the
performance of its part of the contract by the counter party. The risk is not only  due to non
performance but also at times, the inability to perform by the counter party.

The credit risk can be

 Contract risk: Where the counter party fails prior to the value date. In such a case, the
Forex deal would have to be replaced in the market, to liquidate the Forex exposure. If
there has been an adverse rate movement, this would result in an exchange loss. A
contract limit is set counter party-wise to manage this risk.
  Clean risk: Where the counter party fails on the value date i.e. it fails to deliver the
currency, while you have already paid up. Here the risk is of the capital amount and the
loss can be substantial. Fixing a daily settlement limit as well as a total outstanding limit,
counter party-wise, can control such a risk.
 Sovereign Risk: refers to risks associated with dealing into another country. These risks
would be an account of exchange control regulations, political instability etc. Country
limits are set to counter this risk.

Related posts:

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2. Tools to manage foreign exchange risk involved due to fluctuations in exchange rates and
interest rates
3. RBI’s Role in Risk Management and Settlement of Transactions in the Foreign Exchange
Market
4. Foreign Exchange Exposure
5. Economics of the Foreign Exchange Market
6. Settlement of Transactions in Foreign Exchange Markets
7. Flexible v/s fixed foreign exchange rates
8. Official actions to influence foreign exchange rates
9. Management of Foreign Exchange Risks
10. Role of FEDAI in Foreign Exchange