FINANCIAL

FINANCIAL RISK MANAGEMENT MSC-FI 2022/2023 DEC 2022

RISKS FACING INTERNATIONAL BUSINESS

Conducting business internationally carries many risks that domestic business does not.
International business involves exposure to local economic conditions, fraud, and bribery.
Business can be interrupted by political problems such as insurrections, problematic diplomatic
relations, hostility from locals, and volatile foreign governments. Unstable currency exchange
rates and exchange restrictions can also complicate international dealings. Finally, foreign
earnings and investments are subject to restrictions, and tariffs, foreign withholding, and other
tax issues can further restrict returns.

With all of these challenges in play, companies operating internationally should keep a careful
eye on local conditions and internal logistics. Regular visits by an internal audit team will help
make sure risks are effectively controlled and will secure the financial interest of the parent
company. Ultimately, preparation and constant attention are the best protection against threats
to international business.

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.

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 transaction risks, economic risk, operation risk
,foreign exchange risk and political risk.

These challenges may sometimes make it difficult for companies to maintain constant and
reliable revenue. In this lecture, we'll review the strategies companies can employ to reduce
the impact of the risks they face from doing business internationally.

TYPES OF RISKS FACING INTERNATIONAL BUSINESS

TRANSACTION RISKS

Transaction Risk is the exposure to uncertainty factors that may impact the expected return
from a deal or transaction. It can include but is not limited to foreign exchange risk, commodity,
and time risk. It essentially encompasses all negative events that can prevent a deal from
happening.

A deal with a high transaction risk will typically require a higher expected return; therefore, it
is important to consider such risk when evaluating a prospective investment. In some instances,
transaction risk can stop a deal from going through due to potentially negative outcomes
associated with the transaction.

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Common Transaction Risks

Some of the most common transaction risks that can affect the deal or transaction value of an
international business include the following:

1. Foreign Exchange Risk

Foreign exchange risk is the unforeseen fluctuation of foreign exchange, which can affect the
expected transaction value. This risk is especially important to consider for cross-border
transactions or deals with countries that have relatively high currency volatility. Foreign
Exchange Risk is also called economic exposure.

2. Commodity Risk

Similar to foreign exchange, commodity risk considers the unexpected fluctuation of

commodity prices. While commodity fluctuation affects all sectors, it is a primary
consideration in the Oil & Gas and Mining sectors.

3. Interest Rate Risk

Interest rate risk examines how interest rate fluctuation can affect transaction value. Depending
on the changes in rates, this risk can affect the ability of the purchasing party to raise the
necessary capital for the transaction and can impact the debt obligations of the selling party.
For companies that engage in debt covenant agreements with financial institutions, interest rate
fluctuation can impact the company’s ability to meet its obligations established in the covenant.

4. Time Risk

As market conditions and companies change with time, there is a higher probability that the
initial transaction agreement conditions will become unfavorable the longer the negotiation
process is extended. As a result, deals can fall through due to the favorable conditions no longer
being present for both parties. The longer a deal takes to finalize, the longer the transaction is
exposed to the other risks.

5. Counterparty Risk

When engaging in transactions, there is a risk that the counterparty will not complete their
contractual obligations agreed upon in the transaction. In instances where counterparties
default on their contractual obligations, it is often due to the effects of the previously stated
transaction risks.

How to Manage Transaction Risk

To mitigate the effects of transaction risk, some precautions each party of the deal can take
include the following mitigation techniques. These methods used for transaction risk
management are often included in transaction contract clauses or within the deal process.

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Hedging

Companies will engage in hedging arrangements to reduce the level of potential risk from the
price movement of various assets. Hedging provides companies with protection against adverse
changes to asset prices that can negatively affect investment.

Within the context of transactions, companies will often complete hedging arrangements to
reduce the effects of Foreign Exchange and Commodity Risk associated with the deal. To learn
more about Hedging specific to the context of foreign exchange exposure, please see the next
lectures on risk management that will follow after this.

Refinancing

In a fluctuating interest rate environment, companies often look to refinance their debt when
interest rates are declining. Debt refinancing allows companies to reduce their debt obligations
and to borrow at more attractive rates. To ensure that a party is eligible for refinancing, the
borrowing party can include renegotiation clauses in their contracts that allow for refinancing
adjustments when notable interest rate changes.

Due Diligence

To reduce the possibility of the counterparty defaulting on their contractual obligations, parties
will undergo an extensive due diligence process to assess various components of the
transaction before coming to an agreement. In situations where the counterparty has a higher
risk of defaulting, the purchasing party may place a default risk premium into the transaction
agreement to create an incentive for taking on more risk.

Including Risks in Financial Models

When including assumptions in a financial model, analysts will often include predictions for
commodity prices, interest rates, and other factors associated with transaction risk. Including
these assumptions allows analysts to provide comprehensive considerations in their models,
leading to better investment decisions. To consider the profitability of an investment in
both best and worst-case scenarios, analysts can adjust the prices in these situations according
to how they expect market conditions.

Banks susceptible to transactional risk indulge in various hedging strategies through

different money market and capital market instruments, which mainly include currency
swaps, currency futures, options, etc. Each hedging strategy has its own merits and demerits,
and firms make choices from a plethora of available instruments to cover their forex risk that
best suits their purpose.
By buying a forward contract, let’s try understanding a firm’s risk mitigation attempt. A firm
may enter into a currency-forward deal where it locks the rate for the contract period and gets
it settled at the same rate. By doing this firm is almost certain of the quantum of the cash
flow. This helps encounter the risk of rate fluctuations and brings more excellent decision-
making stability.
A company can also enter into a futures contract promising to buy/sell a particular currency as
per the agreement; in fact, futures are more credible and highly regulated by the exchange,
eliminating the possibility of default. Options hedging is also a perfect way of covering rate
risks, as it demands only a little upfront margin and curtails the downside risk to a great extent.

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The best part about the options contract and the main reason they are preferred is that they have
unlimited upside potential. Additional, they are a mere right, not an obligation, unlike all the
others.
ECONOMIC RISK
Economic risk is referred to as the risk exposure of an investment made in a foreign country
due to changes in the business conditions or adverse effect of macroeconomic factors like
government policies or collapse of the current government and significant swing in the
exchange rates.

Economic risks can endanger the ability of a seller to get payment for goods or services in
many ways. This type of risk can sometimes be forecast but is often completely out of the
control of either the buyer or seller. Purchasing transaction insurance is essential for a buyer to
minimize economic risk. Elements of economic risk include but are not limited to:

• convertibility risk
• foreign exchange risk
• translation risk
• central bank activities (interest rate fluctuation, availability of funds)
• economic indicator movement (GDP, unemployment, purchasing power, inflation,
etc.)

Convertibility Risk
Convertibility risk is an issue when a buyer has received the goods promised and is now ready
to make payment but can’t because, for any number of possible reasons, the buyer’s
government bars the conversion of its local currency to that of any other country. The reasons
for this action could be a possible war, a major building infrastructure program, or a massive
negative trade balance. The buyer naturally has the currency of his own country in his bank
account. When the buyer goes to the bank to exchange the local currency to the currency
specified in the purchase contract or to the currency of the seller’s country – or for that matter
the currency of any “hard currency” country, the conversion cannot be made without proper
authorization. Convertibility risks usually occur when the buyer’s currency does not have a
ready world market. Although the transfer of the local currency out of the buyer’s country may
not have been specifically barred, it provides little value since the seller may not be able to find
a buyer for the funds.

Foreign Exchange Risk

Foreign exchange risk is not the same as either transfer risk or convertibility risk. Foreign
exchange risk occurs when the rate of exchange between the seller’s currency and the buyer’s
currency changes dramatically between the time the order is quoted and the time the final
payment is received. When payment is not made in a cross-border transaction, the difficulty of
collection can be compounded significantly, especially if the transaction is hedged. Therefore,
it is much better to assess the level of risk and know ways to mitigate, manage, transfer or
accept the risks.

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Translation Risk
Translation risk involves the revaluation of foreign assets that are held in a foreign currency.
There may be a difference in the current foreign exchange rate from the time of the original
transaction to time of the fulfillment of the sales contract. Assets held on the balance sheet in
foreign currency must periodically be revalued to the current market price of that currency.
This kind of revaluation to the current market will create an exchange loss or gain. This
exchange gain or loss is unrealized but still impacts the value of the assets held overseas.
The second category of risk that international businesses face is the prevailing economic
structures in developing countries. For instance, many multinationals flocked to countries like
Indonesia, Thailand, and Malaysia with great expectations. However, the Asian financial crisis
of 1998 put paid to their economic activities because of the impact of the crisis on the economic
structure of the country. Indeed, prudent economic management is the key aspect here. In these
countries, due to the mismanagement of the economy, the economic crisis ensued and this led
to capital flight from these countries.

The key point here is that international businesses must be prepared to sudden changes in the
economic situation in developing countries since the economies of these countries are not as
deep and resilient like those in the West. Of course, the recent global economic crisis affected
the resilience of the West as well but that is another topic altogether.

Economic risk is the risk faced by a business organization or a company that has a foreign
branch or investment in a foreign country due to factors such as a change in government
policies, change in government, reduction in the credit rating of foreign investment or
significant movements in the exchange rates affecting the business of the entity.

OPERATING RISKS
Operational risk summarizes the uncertainties and hazards a company faces when it attempts
to do its day-to-day business activities within a given field or industry. A type of business risk,
it can result from breakdowns in internal procedures, people and systems—as opposed to
problems incurred from external forces, such as political or economic events, or inherent to
the entire market or market segment, known as systematic risk.

Operational risk can also be classified as a variety of unsystematic risk, which is unique to a
specific company or industry.

Operational risk focuses on how things are accomplished within an organization and not
necessarily what is produced or inherent within an industry. These risks are often associated
with active decisions relating to how the organization functions and what it prioritizes. While
the risks are not guaranteed to result in failure, lower production, or higher overall costs, they
are seen as higher or lower depending on various internal management decisions.

Because it reflects man-made procedures and thinking processes, operational risk can be
summarized as a human risk; it is the risk of business operations failing due to human error.
It changes from industry to industry and is an important consideration to make when looking
at potential investment decisions. Industries with lower human interaction are likely to have
lower operational risk.

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Important: Operational risk falls into the category of business risk; other types of business
risk include strategic risk (not operating according to a model or plan) and compliance risk
(not operating in accordance with laws and industry regulations).

Operating risk is associated with normal day-to-day operations of the business. Every firm
operates within a particular operating environment—both internal and external. The impact of
the operating environment is reflected in the operating costs of the firm. Operating cost is
composed of fixed costs and variable costs. Existence of excessive fixed cost is
disadvantageous to the firm. If the total revenue of a firm having a high fixed cost declines for
any reason, the operating profit will reduce proportionately more.

Business risk is thus a function of the operating conditions faced by a firm and is the variability
in operating income caused by the operating conditions of the firm. It refers to the probability
of losses or inadequate profit due to uncertainties or unexpected events that are beyond control
of the management. It is mainly related to operations of the firm. It is independent of the capital
structure because the rate of return is not affected by the sources from which the funds have
been raised.

There are five categories of operational risk: people risk, process risk, systems risk, external
events risk, and legal and compliance risk.

• People Risk – People risk is the risk of financial losses and negative social performance
related to inadequacies in human capital and the management of human resources. This
encompasses the inability to attract, manage, motivate, develop, and retain competent
resources and often results in human errors, fraud, or other unethical behavior, both
internal and external to the institution.
• Process Risk – Process risk is the risk of financial losses and negative social
performance related to failed internal business processes within every aspect of the
business. This can include product design flaws and internal project failures.
• Systems Risk – Systems risk is the risk of financial losses and negative social
performance related to failed internal systems. This encompasses inter-branch
connectivity, management information and core company systems (enterprise system),
information technology systems, power backup systems, and other technical systems.
• External Events Risk – External events risk is the risk of financial losses and negative
social performance related to the occurrence of external events typically outside of an
organization´s control. This encompasses both natural disasters such as hurricanes,
flooding, earthquakes, and fires, as well as man-made events such as civil disruptions,
war, robberies, arson, road blockades, and terrorist attacks.
• Legal and Compliance Risk – Legal and compliance risk is the risk of financial losses
and negative social performance related to non-compliance with internal and external
regulations and laws. This encompasses non-compliance with CMSA regulations, anti-
money laundering (AML) requirements, tax laws, human resource laws, mandatory
vehicle registration, internal codes of ethical conduct, and other regulations.

FINANCING RISK
Financial risk is the function of financing decisions of a firm. It is associated with the financial
activities of the firm. The genesis of this type of risk lies in the capital structure, i.e. use of the
debt capital. The presence of debt in the capital structure creates fixed payments in the form of
interest, which is a compulsory payment to be made whether the firm makes a profit or not.
Fixed payment in the form of interest or dividend on preference shares causes the amount of

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residual earnings available as dividends to equity shareholders, to be more variable than if no

fixed payment were required.

When debt is used by the firm, the rate of return on equity increases because debt capital is
generally cheaper. Therefore use of the debt capital has a magnifying effect on the earnings of
the equity shareholders—but it adds financial risk. The variability in earnings of the equity
shareholders due to presence of debt in the capital structure of a company is referred to as
financial risk.

Financial risk arises because use of debt in the capital structure increases the variability of the
return of the shareholders. A firm having no debt in its capital structure has no financial risk.
Thus financial risk is an avoidable risk, so far the company is free to finance its activities
without resorting to debt. However it is desirable because, without employing debt in the
capital structure—which is cheaper source of finance—benefit of debt financing to increase
the return of shareholders cannot be enjoyed.

POLITICAL RISK

Political risk is generally defined as the risk to business interests resulting from political
instability or political change. Political risk exists in every country around the globe and varies
in magnitude and type from country to country. Political risks may arise from policy changes
by governments to change controls imposed on exchange rates and interest rates(Barlett et al,
2004). Moreover, political risk may be caused by actions of legitimate governments such as
controls on prices, outputs, activities, and currency and remittance restrictions. Political risk
may also result from events outside of government controls such as war, revolution, terrorism,
labor strikes, and extortion.

Political risk can adversely affect all aspects of the international business from the right to
export or import goods to the right to own or operate a business. AON (www.aon.com), for
example, categorizes risk based on economic; exchange transfer; strike, riot, or civil
commotion; war; terrorism; sovereign non-payment; legal and regulatory; political
interference; and supply chain vulnerability.

Example of Political Risk

A business that operates abroad or that imports things from a certain country can be affected
by the countries’ political and economic environment. As most of us are aware, there have been
constant riots in Venezuela in an effort to overthrow Nicolas Maduro. As one of the counties
with the largest oil reserves, Venezuela is a great business source for U.S. based oil refineries.
However, political instability has caused President Donald Trump to impose sanctions on
Venezuelan oil. This has affected the U.S. refineries that purchase oil from that country.
Additionally, Venezuela is currently facing hyperinflation rates that go above 2 million percent.
This economic instability has led its citizens to live difficult lives. There has been news
coverage on how individuals dig through garbage trucks to find scraps. Once more, President
Donald Trump and other leaders have condemned Nicolas Maduro’s regime on various
occasions. One way this could affect an Oil Refinery business is that if they continue to conduct
business with Venezuela, they might face challenges in importing the oil. They might also not
be able to find other sources of business, which could lead to loss of jobs. These are just “what
if” scenarios.

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How to evaluate your level of political risk

Forms of investment and risk

For a firm considering a new foreign market, there are three broad categories of international
business: trade, international licensing of technology and intellectual property, and foreign
direct investment. A company developing a business plan may have different elements of all
three categories depending on the type of product or service.

The choice of entry depends on the firm’s experience, the nature of its product or services,
capital resources, and the amount of risk it’s willing to consider (Schaffer et al, 2005)

The risk between these three categories of market entry varies significantly with trade ranked
the least risky if the company does not have offices overseas and does not keep inventories
there. On the other side of the spectrum is direct foreign investment, which generally brings
the greatest economic exposure and thus the greatest risk to the company.

Protection from political risk

Companies can reduce their exposure to political risk by careful planning and monitoring
political developments. The company should have a deep understanding of domestic and
international affairs for the country they are considering entering. The company should know
how politically stable the country is, the strength of its institutions, the existence of any political
or religious conflicts, ethnic composition, and minority rights. The country’s standing in the
international arena should also be part of the consideration; this includes its relations with
neighbors, border disputes, membership in international organizations, and recognition of
international law. If the company does not have the resources to conduct such research and
analysis, it may find such information at their foreign embassies, international chambers of
commerce, political risk consulting firms, insurance companies, and international businessmen
familiar with a particular region. In some countries, governments will establish agencies to help
private businesses grow overseas. Governments may also offer political risk insurance to
promote exports or economic development. Private businesses may also purchase political risk
insurance from insurance companies specialized in international business. Insurance
companies offering political risk insurance will generally provide coverage against
inconvertibility, expropriation, and political violence, including civil strife (US Small Business
Administration). Careful planning and vigilance should be part of any company’s preparation
for developing an international presence.

Government policy changes and trade relations

A government makes changes in policies that have an impact on international business. Many
reasons may cause governments to change their policies toward foreign enterprises. High
unemployment, widespread poverty, nationalistic pressure, and political unrest are just a few
of the reasons that can lead to changes in policy. Changes in policies can impose more
restrictions on foreign companies to operate or limit their access to financing and trade. In some
cases, changes in policy may be favorable to foreign businesses as well.

To solve domestic problems, governments often use trade relations. Trade as a political tool
may cause an international business to be caught in a trade war or embargo (Schaffer et al,

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2005). As a result, international businesses can experience frequent changes in regulations and
policies, which can add additional costs of doing business overseas.

Example of a Political Risk

This past year President Trump has imposed 25% tariffs on raw materials like steel and
aluminum coming from China. In turn, China imposed a retaliatory tariff on American
Agriculture. By doing this it American farmers have been hit the hardest by these tariffs. They
are now seeing decreases in overseas purchasing of items like soybeans because other countries
are reluctant to pay the tariffs. China was the number one market for American soybeans, and
without their buying of soybeans, American farmers will have a hard time recovering from this
financial loss. Farmers are also experiencing higher prices on farming equipment, because the
material it is made of had tariffs placed on it. Large businesses like John Deere had to raise
their prices on farm equipment since the metal that they used had tariffs imposed, thus making
the prices higher. While for now, these tariffs seem to only be deeply affecting the American
agricultural business, but there is fear that if metal tariffs increase, more industries like the car
industry will be impacted.

Example of a Political Risk

A trade war is a situation where countries try to damage each other’s trade. The most common
way they do this is by imposing tariffs or quota restrictions. With the recent trade war the
United States and China are having, there are a lot of American companies that are seeing an
impact on their businesses and profits. One company seeing a negative impact is Apple. China
is the third-largest market for Apple and since the market is currently unstable in-between the
countries, Apple is skeptical about long-term outlooks. Analysts have stated that if the China
market collapses, then Apple’s global market is going to fail. Apple has already seen a 10%
drop in their stock and a 3% drop in the Dow Jones industrial average.

Common types of political risks

To better understand the impact that certain political risks can have on your business, let’s look
at three of the most common types and real-world examples.

1. Expropriation/government interference
This risk measures the likelihood of government action or weak governance conditions having
a significant impact on a country’s commercial environment.

Real-world example: Following a coup attempt in 2016, the Turkish government targeted
those domestic companies associated with the Gulen movement, which it claims was behind
the attempt. The actions have included arbitrary impositions of regulatory requirements up to
outright expropriation. The impact to overseas companies has been that they have needed to
add a further level of counterparty due diligence to any business dealings with Turkish
companies to determine their relationship with the government. The same case in Tanzania in
1967 Azimio la Arusha, India 1969 and other cases.

2. Transfer and Conversion

Measures the likelihood of a government imposing conversion or transfer restrictions on the
currency, which would significantly affect the commercial environment.

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Real-world example: Faced with an economic and financial crisis, Lebanon has been looking
at formally instituting capital controls to conserve the limited foreign exchange reserves that
remain in the country. This would significantly impede overseas companies doing business in
Lebanon to transfer funds out of the country. The same case in Russia in 2015 and 2022
restricted short-term transfer of funds from the country to elsewhere on the globe.

3. Political violence
Political violence is defined as any violent or hostile acts undertaken with the primary objective
of either changing or overthrowing the government of the country or changing its policies.

Real-world example: A recent example of political violence is the conflict in Ukraine.

Russia’s invasion of the country in early 2022 has significantly increased the risk to overseas
companies operating in Ukraine. Political violence can also take the form of social unrest as
seen by recent events in Pakistan and Sri Lanka.

Preparing and protecting business against political risk

The impact of any one of these events on a foreign exporter’s business is unlikely to be isolated
or short-lived, and may ripple across the entire company, aggravating other types of risk all the
way back to foreign country business.

So, how can overseas exporters prepare for what may be sudden and unexpected political risks?

• Due diligence, ongoing research and political risk analysis are perhaps the most
important foundational elements of any emerging market business strategy. Speak
with trade agencies in the local and foreign country who have experts on the ground in
most emerging markets.
• Consider diversifying your overseas investments, so that all your risk isn’t concentrated
in just one or two emerging markets. Have a clear and current political risk mitigation
strategy based on the “what ifs” in your market. Know ahead of time how you’ll
respond to a range of risks.
• If possible, involve your key external stakeholders in political risk mitigation. Brief
customers, suppliers and agents on your contingency plans for dealing with unexpected
political risk and if appropriate, co-ordinate your risk response.
• Recovering from an adverse political event is likely to be quicker and easier if you
prepared for it ahead of time and can co-ordinate your response with your most
important stakeholders.

Trading in emerging markets can be daunting, which is why having a detailed plan and risk
mitigation strategy in place from the outset is essential as the case is vivid in Sri Lanka, Brazil,
Mexico, Venezuela, Kenya etc.

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

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often outline in their 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. There has been political risk insurance at Nairobi, East Africa. Now the
case of Tanzania to observe the same given its earlier expropriation in the 1967.

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