Risk happens on account of uncertainty about happening of an event like loss, damage, variations in foreign exchange rates, interest rate variations, etc. Every business manager is always risk averters, i.e., managers usually do not want to take risk. Hence, he likes to work out higher probability for creating wealth and profit. He likes to work as hedger.
The risk taker would like to take risk. He normally works as speculator. Any change in the business environment, would bring the same type of risk. Generally, the areas of business prone to risks are shortage of inventory, shortage of business orders, shortage of manpower, shortage of utilities like power and fuel, changes in government policies, etc.
The international business faces the risk due to the following reasons:
- Operations across and with different political, legal, taxation and culture systems.
- Operations across and with a wider range of product and factor markets, each with different levels of competition and efficiency.
- Trades in wider range of currencies and frequent resort to foreign exchange markets.
- Unregulated international capital markets.
In other words, risk is the main measurement of the probability of incurring a loss or damage. The chance and possibility that the actual outcome from an activity will differ from the expected outcome normally gives rise to risk. This means that, higher the variability the possible outcomes that can occur (i.e. broader the range of possible outcomes), results in to greater risk.
Types of Risks:
The value of firm’s assets, liabilities, operating incomes, operating expenses, and other abnormal incomes, expenses differ from expected one clue to changes in many economic and financial variables like exchange rates, interest rates, inflation rates etc.
The appreciation of a local currency results in decreasing the local currency value with respect to exports receivable denominated in foreign currency. Such appreciation or depreciation of local currency makes effect on the cash flow of domestic currency due to the transactions’ exposure of merchandise and non-merchandise exports and imports.
Exposure is a measure of the sensitivity of the value of a financial item (cash flow, assets, liability etc.) to changes in variables like exchange rates, etc., while risk is a measure of the variability of the value of the financial item.
A firm always encounters a number of risks during the course of business, i.e. political instability, technical obsolescence, availability of skilled labour, extent of trade unionism, infrastructural bottlenecks and financial risks.
Generally risks which a firm has been categorized as:
- Foreign exchange rate risk
- Interest rate risk
- Credit risk
- Legal risk
- Liquidity risk
- Settlement risk
- Political risk
Let us now discuss about all these risks in detail.
Foreign Exchange Rate Risk:
The variance or changes of the real domestic currency value of assets, liabilities or operating income on account of unanticipated changes in exchange rates referred as Foreign Exchange Risk. This risk relates to the uncertainty attached to the exchange rates between the two currencies.
If an Indian businessman borrows some amount viz. dollars and has to repay the loan in dollars only over a period of time, then he is said to be exposed to the foreign exchange rate risk during the currency of loan.
Thus, if the dollar becomes stronger (costly) vis-a-vis rupees (cheap) or depreciated during the period then the businessman has to repay the loan in terms of more rupees than the rupees he obtained by way of loan. The extra rupees which he pays are not due to an increase of interest rates, but because of the unfavourable foreign exchange rate.
On the contrary, he gains if the dollar weakens vis-a-vis rupee because of favourable exchange rate. Anyway, the businessman would like to protect his business from unfavourable exchange rate by adopting a number of hedging techniques and would like to optimise his gains in case of favourable exchange rate situation. This mechanism, in short, is known as Foreign Exchange Risk Management.
Indian business was not very much exposed to this risk as the exchange rate in India operated in RBI controlled regime. However, with the advent of the budget for 1993-94, a new era was ushered in by opening up Indian economy to the International market.
The various steps taken for encouraging globalization have made the Indian business vulnerable to foreign exchange rate risk. Hence, exchange rate risk exposure is considered to be an important factor while conducting business in India.
The types of foreign exchange risks and exposure are:
- Transaction exposure
- Translation exposure
- Economic exposure, and
- Operating exposure
2. Interest Rate Risk:
The fluctuations in interest rates over a period of time change the cash flow need of a firm, for interest payment. The rate of interest is decided and agreed among parties (i.e. lender and borrower) at the time of sanctioning of debt.
The interest rate may be constant or may be related to some other variable or benchmark. If it is constant, it is known as, ‘Fixed Interest Rate Debt Instrument’ (FXR). If the rate is linked to any other variable or benchmark say LIBOR (London Inter-Bank Offer Rate) then known as Floating Interest Rate Debt Instrument (FIR).
Interest Rate Exposure and Risk:
Interest rate uncertainty exposes a firm to the following types of risks. Borrowings on floating rate bring uncertainty relating to future interest payments, for the firm. The floating rate makes borrowing cost of capital unknown.
The problem is that there is a rise of variation in interest rate risk for the firm due to the fluctuating or floating rate clause in loan agreement. Hence, firm management not sure about the interest payment they have to make whenever interest amount is payable to financial institutions or lenders of the funds. Borrowings on fixed rate basis results in risk if future periods interest rates may come down, and the firm has to continue with a heavy burden on debt servicing.
In the Indian environment, the management of interest rate risks has been a comparatively new concern. The behaviour of interest rates during the period of 2003-2008 has upset the cost and return calculations of many industries.
The exchange rate fluctuation in the South East Asian Countries or the nosedive (sudden plunge or changes) of rupee in terms of dollars shows the extreme sensitivity of exchange rates, and in turn the extent to which the firm’s exposures affected.
Interest rates in India were regulated and controlled by the dictates of the Reserve Bank of India. This ensured a stability of interest rate mechanism and the Indian business was not very much bothered about them. However, with changes being brought out by the Government and Reserve Bank of India, it is quite clear that interest rates will henceforth be market driven.
A credit risk is the risk, in a transaction, of counter party of the transaction failing to meet its obligation towards the transaction. This risk is present in all trade and commerce transactions, thus it also includes the transactions relating to foreign trade and foreign exchange.
The risk arising due to legal enforceability of a contract or a transaction is known as legal risk. The contract is normally unenforceable due to pending, or newly created, political and legal issues between the two trading countries. The various legal taxes, controls, regulations, exchange and trade controls, controls on financial transactions, controls on tariff, and quotas system, are risks factors or elements in foreign trade and finance flows.
If the markets turn illiquid or the positions in market are such that cannot be liquidated, except huge price concession, the resultant risk is known as liquidity risk. It can also be termed that the risks which, though directly or indirectly, affect the liquidity and in turn long term solvency of the parties in the market, is known as liquidity risk.
The international financial system failed to support the increasing demands of expanding trade and finance due to lack of enough resources, efficient and quick actions of surveillance on capital flows and inadequate liquidity to meet emerging crisis situations.
This is the risk of counterparty failing during settlement, because of time difference in the markets in which cash flows the two currencies have to be paid and received viz. settled.
Settlement risk depends on the various risks like risk of the borrowing company’s ability to meet its debt service obligation in time, represented by the risk of its business, financial risk, market risk, labour problems, restrictions on dividend distribution, fluctuations in profits and a host of other company related problems. Unanticipated depreciation of a country’s currency might hurt a company which is net importer but it may benefit exporter.
Political Risk is the risk that results from political changes or instability in a country. Such variability or changes always result into some kind of changes in the monetary, fiscal, legal, and other policies of the country facing the changes.
It has adverse impact on the working of the financial and commercial operation carried out by the country with the globe, and also of foreign enterprise located in host country. When a factor of instability is found with a country, such kind of risk crop up, and affect the foreign trade and exchange of the country adversely. The political risk results in to uncertainty over property rights and protection of wealth.
Types of Political Risk:
Political Risk makes the impact on direct and indirect investments in the host country as well as the inter-trading transactions. The government measure also tends to limit the working and operations of foreign firm in the country.
Political Risk can broadly classify into the following four categories:
- Country Risks
- Sector Risks
- Project Risks
- Currency Risks
1. Country Risks:
Country risks emanate from political, social and economic instability of a country, and bring hostility towards foreign investments. The hostility develops during the periods of crisis and forces the few governments to nationalize core industrial sectors based on strategic importance of the same.
The political risk takes several forms, such as nationalization or expropriation without indemnity (Compensation). The major episodes in this context are nationalization in Iran (1978), Libya (1969), Algeria (1962); nationalization with indemnity, such as in Chile (1971). Above all latent Nationalisation in terms of compulsory local or governmental participation constitutes another variant of political risk.
The concerns may veer (opinion or moving around some perception related questions) round the following questions:
- How stable is that government?
- Are government policies reasonably consistent over time?
- Is political power concentrated or diffused? Is it administered by a strong central government or by a more federal allocation of power?
- How insulated is the government from changes in public opinion, particularly with respect to foreign investment and trade issues?
- Is the government relatively strong or weak?
- What is the country’s record of compliance with international agreements, including sovereign debt obligations?
- How strong is the rule of law? Are laws and contracts generally enforced by an accessible, fair, and impartial judiciary?
- Are there social and economic factors of special concern (for example, environmental protection, human rights, labour standards, or inequitable allocation of wealth or income)?
2. Sector Risks:
Generally, sectors like Petroleum, Mining, and Banking and so on are the sectors which are prone to greater element of political risk in a country in comparison to other sectors, because such sectors directly affect the climate for foreign investment.
For instances, petroleum sector has been nationalized in various countries such as Mexico (1938), Libya (1968), Iraq (1972), Venezuela and Kuwait (1975), Iran (1978) and Nigeria (1979). Likewise, nationalization of copper mines took place in Zaire, Zambia, and Chile and of Iron mines in Venezuela. Banking sector was nationalized in Guinea (1962), Vietnam (1975) and Iran and Nicaragua (1978).
Generally, not only country and sector but also the specific project is subject to risk. Multinationals establishes big projects in foreign countries, like electricity generation plants, dams, exploration of petroleum fields, etc. such project requires a huge investment in the beginning and as gestation period is long enough the risk enhances.
In the event of the project turning to be successful (for example finding an exploitable petroleum field), some governments are very demanding, and in certain situations, in particular, with the change of government the latter may even refuse to respect the engagement of the predecessor. In the year 1995, a new Government of the Maharashtra State in India refused to fulfill the agreement of the previous government for a large electricity project, named Enron project.
The need happens to focus on analytical framework before taking up an activity, to ensure that effective risk management can be achieved in practical context. The risk management activity to be undertaken with respect to particular industry, sector and/or project and also the nature of parties involved in it, hence, the integration of all parameters is needed.
The assessment and determination of risk is a highly subjective and theoretical. In such circumstances, the decisions taken by the managers are more often influenced by management’s view of the future of the sector, and their desire to achieve the excellence performance, in addition to their knowledge based on past experience.
A currency risk arises due to imbalance in the balance-of-payments of a country. In last decade, changes in the macro-economic situation and resulting national controls on capital flows and foreign investment and borrowings resulted into Asian crisis. It is needed to monitor various macro-economic situations and national control as they result into currency risk and it affects the private sector infrastructure projects.
In short, risk can be evidenced when the exact relationship between the causes of risk and its impact on the economy cannot be established. For this purpose by application of the statistical techniques, probabilities can be worked out for each possible event. It is always solely subjective assessment.
Risk analysis, being a component of risk management process, deals with the various kinds of events and causes and effects of these events which may resultantly cause harm to the functioning of the firm. Risk analysis supports the business managers to work out the proper decisions in business working.
Risk analysis is done on the basis of the possibility of an event taking place. Thus, the risk of an event can be measured through the possibility (probability) of the event taking place with regards to the frequency and severity.
An event can have wide variety of characteristics or possibility with respect to varying degrees of seriousness, depending upon its nature and the extent of damage it can create, and the perception of the event’s occurrence taken by the management. Each project or activity can have many associated risks, and these risks can vary depending upon technology, funding, organisations involved etc.
However, in broad terms, the key sources of project or process risks are like:
- Commercial risk
- Financial risk
- Legal risks
- Political risks
- Social risks
- Environmental risks
- Communications risks
- Geographical risks
- Geotechnical risks
- Construction risks
- Technological risks
- Operational risks
- Demand or product risks, and
- Management risks etc.
These sources of risk directly influence the project-specific and non-project-specific performance. The analyst is supposed to define the boundaries of each risk driver and its detailed risk elements. Then, he/she has to move to estimate the impact of the same.
The decision with respect to division of risks into specific element; and later on evaluates. The parameters of evaluations are generally affected by personal subjectivity and belief of the financial analyst. The risk analysis explores the avenues for business managers to take informed decision.