This paper examines the nature of risk in international financial markets and the strategies businesses and investors use to minimize exposure to foreign exchange fluctuations. Drawing on Eatwell and Taylor's analysis of global finance, the paper discusses how the U.S. economy's current account deficit and weakening dollar create particular vulnerabilities. It then surveys four key risk-minimization techniques: transferring transaction exposure, netting out across multiple currencies and markets, using currency options to preserve gains while limiting losses, and employing currency swaps to avoid credit risk. The paper concludes that effective international risk management ultimately requires cross-border cooperation and transparent disclosure among business entities with shared financial interests.
No profit was ever made without taking some financial risk. However, economists such as John Eatwell and Lance Taylor have argued in their text Global Finance at Risk: The Case for International Regulation that international financial markets are intrinsically and particularly apt to pose the threat of risk to potential investors at both the individual and corporate level. Investors in finance base their decisions on guesses — not only about how other investors within a nation will behave, but also about national stability, which affects the stability of the currency.
As markets have grown more global in scope, industrialized countries have often pursued a more cautious monetary policy regarding other nations. However, too much caution can itself be risky. Ultimately, hesitancy in investment results not only in lost opportunities, but in a climate of fear that can, at its extremes, generate international deflation, a depression in economic growth, and unnecessary limiting of international development. (Eatwell & Taylor, 2000)
Still, most international and national businesses prefer minimizing their potential exposure to foreign exchange risks. Risk must be embarked upon, but judiciously.
Unfortunately, the U.S. economy has become particularly vulnerable to charges of risk because of its current account deficit with other nations, the unwillingness of foreigners to buy U.S. securities based on the increasing national debt — which shows no signs of abating — and the perception that U.S. consumers as a whole lack confidence in their economy's growth potential. (Eatwell & Taylor, 2000) The U.S. dollar has been steadily weakening as a result.
The United States' continued investment in Iraq and the ever-strengthening Euro do not bode well for the dollar as a currency, although investors with no political or personal interest in the U.S.'s financial health can at least take comfort in the apparent stability of this downturn when hedging their investments in the dollar's fortunes, if not in its overall impact upon the United States' economy and goods sold abroad. (Schnaue, 2004)
Besides out-and-out hedging, two ways in which transaction exposure can be minimized are transferring exposure and netting transaction exposure. "The first of these is premised on transferring the transaction exposure to another company." (Kelly, 2001) An example of this would be when a U.S. exporting firm could quote the sales price of its product for sale in Germany in dollars. To avoid the German importer facing the transaction exposure resulting from uncertainty about the exchange rate, one means of transferring exposure would be to price the export in Deutsche Marks "but demand immediate payment, in which case the current spot rate will determine the dollar value of the export." (Kelly, 2001) Thus, the institution could minimize the risk of potential flux in the currency for the German firm and encourage investment. This fixing of the rate could be accomplished either way, for both sides of the transaction, depending on the needs of the company.
A second way in which transaction risk can be minimized is by "netting out," or diversifying across different markets and currencies. "This is especially important for larger companies that do frequent and sizeable amounts of foreign currency transactions. Transaction exposure is further reduced when payments and receipts are in many different currencies. Foreign currency values are never perfectly correlated. Therefore, an unexpected increase in the value of the French Franc may improve the profit margin on receipts from France." (Kelly, 2001) Multinational corporations can often reduce their respective long-term currency risk exposure by arranging parallel or back-to-back loans, another form of diversifying investments. Diversification allows for the different factors affecting varying regions — from politics to weather — that can impact national currency stability.
"Options markets limit losses while preserving gains"
"Swaps eliminate credit risk in parallel loans"
This last method highlights one key aspect of minimizing risk and maximizing profits while still engaging in fruitful and dynamic financial transactions: to minimize risk in financial markets on an international level, cooperation between business entities that crosses borders is necessary. Because of the obscure nature of the factors affecting currency exchange rates — including politics and international economic conditions — business entities with mutual interests in financial stability must work together to minimize their own shared risks regarding exchange rates, loans, and currency values. They must do so by freely allowing for differentials in rates and by disclosing all known information about their country's, company's, and currency's financial health.
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