International Finance Currency Risk Arises

International Finance

Currency risk arises when a company is exposed to the volatility of a currency pairing over time. For a Canadian firm operating overseas, the currency risk would come when cash flows from the subsidiary are brought back to Canada. This is the main type of currency risk, known as transactional (Investopedia, 2009). The firm is receiving income in another currency -- euros for example -- and the value of that income will change over time as the exchange rate between the euro and the Canadian dollar fluctuates. The value of the euro income could increase over time, but it could also decrease over time. The other form of currency risk is translational, and is more difficult to hedge because the risk is incurred even if the foreign income is not repatriated. It will be repatriated on the income statement regardless of whether or not the euros ever came back to Canada.

It is important to hedge foreign currency risk because hedging provides stability of cash flows. When money is going to be repatriated, the Canadian company will probably want to have certainty with regards to the value of that money. If the Canadian company does not need certainty, then it does not need a hedge. However, exchange rate fluctuations can impact the profit margin of a deal. For example, a Canadian company sells a product to a Germany company for €100,000. At the time the deal is struck, those euros are worth $155,000. The Canadian company's cost is $145,000. Therefore, it makes $10,000 on the deal. If the euro increases in value, the Canadian company may receive $165,000 for the deal, increasing its profit to $20,000. But if the euro decreases in value, the company may only receive the equivalent of $145,000 by the time the money arrives, meaning that they do not make any money at all on the deal. Minimizing this risk is the role of foreign exchange hedging.

There are multiple hedging strategies available. One is an operating hedge, where the Canadian company spends its euros in Europe. Thus, the euro income is never brought back to Canada so it is not subject to transaction risk. If the money must be repatriated, there are many types of products that can be used to hedge. These include forward contracts, interest rate swaps, futures, and foreign currency options (Harper, 2009). Each of these products has unique characteristics, but each can allow the company to ensure certainty of cash flows arising from foreign currency transactions.

The underlying philosophy with all of these is that they deliver cost certainty. The firm pays a small price and surrenders some upside for the opportunity to eliminate downside risk. It is important, then, that the firm understands the limitations of each of these hedging types and that it shop around for the best deal on these derivative and hedging products.

Question 2. There are many factors that should be considered with respect to making a foreign direct investment. The size of the market and its characteristics must be considered, to ensure that there is ample opportunity in the market. The expertise of the firm should be a factor, since expertise in a given market, or type of market, can play a significant role in organizational success.

The governmental/legal environment must be carefully considered. Each country has its own approach to FDI, some being more open than others. In many cases, the form of the FDI will be dictated by government policy. For example in many countries governments strongly favor joint ventures with local firms.

The type of investment is perhaps the most important decision that needs to be made. There are a number of options. Some include licensing/technology transfer, where the investing firm hires a local firm to produce the product or service. Reciprocal distribution agreements allow for the firm to have its products sold abroad, typically in exchange for opening the domestic market to the foreign partner. Joint ventures and strategic alliances result in tighter partnerships, with the subsidiary being owned by both parties. A greenfield subsidiary involves the firm setting up a facility from scratch. Portfolio investment involves making minority investments in overseas companies in order to gain some say in their management (Graham & Spaulding, 2005).

There are many ways to reduce the risks inherent in FDI. Having a local partner -- a joint venture most likely -- mitigates multiple risk types. The local government is more likely to be favorable and the local partner has expertise in the market with respect to marketing, distribution, the legal system and the hiring practices. Local partners also come with build-in distribution channels and sales forces, which represents an advantage over greenfield subsidiaries in particular.

Another way to mitigate the risk of FDI is to hire a consultant. The consultant can provide valuable information about operating in that market. This information can help to prepare the company for the challenges that it will face by identifying and addressing those challenges ahead of time.