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.
- 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.
The types of foreign exchange risks and exposure are:
- Transaction exposure
- Translation exposure
- Economic exposure
- Operating exposure
- 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).
- Credit Risk
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.
- Legal Risk
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.
- Liquidity Risk
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.
- Settlement Risk
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
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
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.