Types of Risk in International Finance

sonal gupta

International finance is an essential tool for businesses to grow and expand. However, there are many risks involved in this type of financing. Some of these include foreign exchange risk, legal risk and financial risk.

Foreign exchange risk is the change in the real domestic currency value of assets, liabilities or operating income on account of unanticipated movements in the foreign currency market. This risk is a major challenge for exporters and importers.

Market Risk

Market risk is the potential for losses that may occur as a result of unfavourable price movements in financial markets as a whole, from commodities to stocks and bonds. These fluctuations can cause investment portfolios to lose value, affecting investors and businesses with exposure in foreign markets. Market risk can be mitigated by diversification, hedging, asset allocation and regular risk monitoring.

Market risks include equity risk, interest rate risk, commodity risk and currency risk. Each type of market risk has different sources and can impact a portfolio in a unique way. Systematic market risk, also known as non-diversifiable or residual risk, can’t be eliminated through diversification; however, specific risk that is unique to individual companies and industries can be reduced by using strategies such as hedging and hedge funds. The globalization and transformation of financial markets is changing the way that market risks are managed.

Credit Risk

Credit risk is the potential loss incurred by lenders if they extend credit to borrowers who may not abide by contractual terms and conditions. It can result in lost principal and interest, disruption to cash flows, and increased collection costs. Credit risk can be found in loans, advances and other off-balance sheet items like letters of credit, guarantees and documentary credits.

Public entities with which due diligence reveals that the buyer has the implicit full faith and credit/support of a sovereign or that the likelihood of sovereign liquidity and solvency support is exceptionally high in both recovery and default prospects. This includes government-owned entities with a near monopoly on operations in a sector (e.g. power, oil and gas).

Examining a client’s or potential client’s revenue stability and diversity, debt-to-equity ratio, profit margins, growth rate, industry classification and other factors can help determine its level of credit risk. The industry’s competitiveness and the extent to which it can weather economic trends and volatility are also important factors.

Currency Risk

A company’s market value is impacted by unexpected currency fluctuations. Also known as forecast risk or economic exposure, it can be found in multinational companies that have subsidiaries worldwide and that engage in a lot of transactions in foreign currencies.

Currency risk is a risk that any business involved in international trade or making international investments faces due to unanticipated exchange rate movements. It is one of the three main types of risk that affects multinationals, export import businesses and investors that make foreign investments.

Transaction exposure is the most common type of currency risk and occurs when a contract between two parties specifies prices in one currency but the cash flow date that corresponds with payment is in another. For example, if you receive payments from abroad in Chinese yuan and then report financial statements in Canadian dollars, the yuan could appreciate against the dollar between when you signed the contract and when you actually receive your payment.

Country Risk

Country risk is the possibility that a country will default on its financial commitments. This type of risk can occur due to a variety of reasons, including political instability and economic woes. It can also arise from natural disasters or war.

While some risks can be diversified away through hedging, others are difficult to hedge against. Political risks are especially dangerous to investments, as they could affect a country’s willingness to pay debts and maintain a hospitable climate for investment.

Investors should consider the riskiness of a country when valuing assets or determining an appropriate discount rate. Quantitative measures like sovereign yield spreads are useful, but investors should look at qualitative factors as well, such as the political situation and news, social stability, monetary policy, growth potential, and investment profiles of a country. These factors are often updated regularly. The country risk of an asset should be compared with that of its peers.

Operational Risk

Financial risk can result from a variety of factors. For example, businesses may face financial risk from fluctuating market interest rates or their inability to pay debts or income. Businesses also face financial risk if they make poor management decisions that jeopardize their business’s profitability and liquidity.

To mitigate operational risk, banks must prepare leaders, business staff, and specialist teams to work differently. They must be able to adapt their legacy processes and controls while embracing agile development, data exploration and interdisciplinary teamwork. They must also acquire the skills to manage fraud and conduct risks — such as account churning, third-party theft, bribery, and market manipulation — in new ways.

Berg-Yuen and Medova [1] survey 279 academic papers on the frequency and severity of operational risk losses in financial institutions and identify a number of determinants that can be considered business environmental and internal control factors (BECIFs). They suggest that such factors should form a core component of bank risk measurement systems and that they should be used to determine the required regulatory capital a firm is required to set aside for operational risk.

Financial Risk

Financial risk is the possibility that a business will incur losses due to things like market volatility, hikes in raw material costs, changes in foreign currency values and the chance of debt default by government entities. It is also the risk a company takes when it extends credit to customers or its suppliers. Other forms of financial risk include liquidity risk and translation risk.

Several circumstances can create financial risk, such as the collapse of Toys “R” Us, the failure of banks and large companies to pay their debt obligations or significant changes in interest rates. There are also physical risks that can occur when a company expands its operations overseas, such as sea level rise or increased severity of natural disasters that could damage property values. The risks that come with international expansion can be mitigated through proper planning and a strong internal controls framework.

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