International financial management is extremely important for company that operates in international market. This however, leads to many risks and challenges that need to be managed properly.
1. Foreign Exchange Risk and Hedging
Value of money nowadays has no intrinsic value and is based on relative trust (Fiat Money). This is due to the fact that in the past, the cost of producing money used for transaction (i.e. gold, silver, alloy coin) were higher than the real value of it.
This leads to Contractual Exposure (or transaction exposure) due to nominal exchange risk (based on nominal price) where there are uncertainties of assets and liabilities’ value (which are denominated in foreign currency) that expires at some future point in time.
Example : You import 1,000kg of Spices from India, the costs of goods will depend on the value of the Indian Rupee relative to the home currency. Time also plays a role in fluctuating the exchange rate between currencies. The stronger the Rupee, the more expensive it is for us to pay, vice versa.
Hedging also has the same issue. Put simply, hedging works like a bumper that dampen the negative impact of an adverse event which might happen in the future (also used to maintain competitiveness). However, this could also lead to adverse consequences if risk manager failed to strike a balance between uncertainty and opportunity cost when deciding on their hedging policy. In other words, it can literally make or break a company. Some financial instruments that are used are forwards, futures, options or swaps.
2. Segmentation of Consumer-Goods Market (Real Exchange Risk)
The consumer goods and services are separated by regions and are usually prices locally. This segmentation makes the amounts traded in the market to be be small, resulting in high logistical costs. Furthermore, prices are also sticky (due to menu cost) even when prices rise (along with GDP).
These lead to Economic Exposure due to real exchange risk where the market value and competitiveness of companies and countries heavily depends on the real appreciation or appreciation of its currency.
Example : ‘Swissie‘ – during the Eurozone debt crisis in 2011, Switzerland’s Swiss Franc (CHF) strongly appreciated relative to the Euro (EUR) due to its healthy public finances and political stability. This over-valuation of CHF did more harm than good to Switzerland. Swiss exporters lost its competitiveness; local consumers shopped outside of the country; tourists went elsewhere, all due to its high currency rate. To combat this, in September 2011 Swiss National Bank (SNB) intervened by implementing buy-back policy of Euro should CHF increase above 0.83 EUR/CHF.
This synthetic peg helped to sustain Switzerland’s export-driven economy, but it swelled the central bank’s balance sheet. Worried that the accumulation of foreign reserves and massive printing of Swiss Franc will lead to hyperinflation (though the chances are low since its inflation level is very low) along with ECB’s plan of quantitative easing, SNB decided to drop its synthetic peg and allowed its currency to float freely. In the same business day, it increased by almost 30% and 25%, against Euro and USD respectively.
This sudden float led Swiss stock market to fall since it became difficult for Swiss companies to sell their wares abroad and the forecasts on Swiss economic growth rates were downgraded. Not only that, Banks, brokers and individual (as well as hedge funders) lost millions in consequence.
3. Credit Risk
Not only that, there will always be at least two legal systems involved in the case of credit issue, there are also unrecoverable account receivable risks. To regulate this, contracts and stipulations are commonly used.
4. Political Risk
When a government decides to impose currency controls, one’s money in that particular country’s (foreign) account will not be able to be retracted; this risk is called a Transfer Risk. Another issue is Expropriation (dispossessing) or Nationalisation of an industry or business sector by the government (i.e. Oil and BP).
5. Valuation
Valuation (NPV) of a project with foreign cash flow is no easy task. Domestically, we can use Capital Asset Pricing Model (CAPM) to calculate the theoretical rates of return of an asset (or project); internationally, we need to adapt this model into International Capital Asset Pricing Model (ICAPM). The latter model factors foreign currency risks along with its premium into account.
6. International Tax Issues
There are also potential risks for double or even triple taxation for those who gain revenue from countries other than their home-country. However, there are already many tax treaties between countries to neutralise these multiple taxations.
References: Bekaert, G. and Hodrik, R. (2009). International Financial Management, International Edition. Pearson.; KU Leuven Lecture Notes.
Meletaō 