Economic Risk

Economic Risk Management118.Gourav Kumar Ganguly139.Gaur Hari Pal 151. Siddhant SethiaGroup 7| PGDM-B | SIMSR

1.Economic risk2.Principal economic risks in international markets3. Exchange Risk Management a) Exchange rate risks b) Exchange risk management c) How foreign investors can protect themselves from these exchange rate risks d) Standard methods of hedging an exposed dollar liability4. Economic Freedom Index5. Uncontrollable Risks

Roadmap for economic risk

Economic risk

Economic risk:

An economic risk can be defined as the likelihood that economic mismanagement will cause drastic changes in a country's business environment that hurt the profit and other goals of a particular business enterprise.

Countries often impose restrictions on business activities on the grounds of national security, conserving natural resources, scarcity of foreign exchange, to curb unfair trade practices, to provide protection to domestic industries.

Hence it is essential to know whether potential risks outweighs the benefits.

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Principal economic risks in international markets are:Exchange controlsLocal content requirementsImport restrictionsRestrictions on fund flowRun away inflationHigh DebtBalance of paymentTrade deficit

Exchange controls:Scarcity of foreign exchange exchange control measure in a country.Adverse affects:repatriation of profits and repatriation of sales proceeds to the home country

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Local content requirements:Local content requirements for -extending export incentives or putting a country-of-origin label. Examples:EEC termed assemblers as screw driver operations and imposed a local content requirement of 45 percent. NAFTA imposes 62.5% as local content requirements for cars manufactured in member countries.

Import restrictions:To protect domestic industry, governments often impose selective ban on import. Such restrictions vary from total ban on imports to quota restrictions. This leads to higher product costs and comprise on the product quality.

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Exchange rate risks

Many countries have been experiencing ongoing fiscal deficits,rapid money-supply growth,high inflation rates.So devaluation crises appear from time to time.

Recent devaluation episodes includes:Mexican crisis of 1994,Asian crisis of 1997, Russian crisis of 1998These events have shown what heightened foreign exchange volatility can cause.

Capital flows have become more sensitive -countrys financial system and economic conditions than they have been in the past

We all are aware of the recent devaluation episodes and their adverse effects on the economies of these countries.7

How foreign investors can protect themselves from these exchange rate risks ?Here are some ways managers can cope with these country risks:

1.Host country currency Devaluation assessment:The theory of Purchasing Power Parity provides a guide to likely exchange rate changes. Compare a countrys cumulative inflation over a number of years with the cumulative inflation rate of its major trade partners. If the difference in cumulative inflation rates exceeds the percentage change in the foreign exchange rate, then devaluation is a real possibility.

2.Purchase price spread over a long time period:This allows domestic currency to be purchased at a lower cost if devaluation occurs.

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3.Negotiate a lower price with the supplier:

The extent to which this can be done will depend upon the relative bargaining power of the buyer and the seller and the profit margin of the seller.Price revision based on a band e.g. 10% for exchange rate and raw material rate.

4.Absorption of the price increase:

The extent possible by the buyer and pass on the rest to the consumer. The extent to which this can be done will depend on the profit margin the buyer enjoys and the competitive and the demand conditions prevailing in his market.

5.A third and complementary, approach is to take steps to minimize exchange risk.

The four most common ways of doing this are exchange risk avoidance, changing sourcing, exchange risk adaptation and currency diversification. Of these four approaches , exchange risk adaption is most commonly used.

Also we can have a price revision band lets say of+/-10% band wherein if the exchange rate depreciates by more than 10% the supplier compensate the customer and vice versa.9

5 A. Risk avoidance

Exchange risk avoidance strategy -avoids foreign currency transactions.applicable - firm which makes all its purchases and sales with local buyers only.Expose the business to the possibility of interest rate increases as a result of a central banks response to foreign exchange rate devaluation. For foreign-owned financial institution: Possibility of a run on deposits if the depositors seek to withdraw funds in order to transfer them aboard.impractical strategy as most industries: use imported materials, export some of their output,compete with imported products

5 B. Changing/ Diversifying sourcing:

Another strategy is to change the source of purchasing.For e.g. If the US goods becomes costlier due to dollar appreciation, then change the source from US to some other countries where the product is cheaper either due to depreciation of their currencies or other reasons.A no. of companies have diversified the countries of sourcing to spread and minimize the risks of exchange rate fluctuations.

Page 239 for risk avoidanceRisk avoidance strategy avoids foreign currency transactions .calls for purchase and sales within the country itself.A rather not widely used strategy as most industries use imported materials, export some of their output and compete with imported products, so exchange rate does play their part.

Diversifying sourcing:This strategy talks about changing the source of purchasing.State the e.g. of US

(US changing from Japan to China. And now from China to Vietnam.)

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5 C. Currency Diversification

Currency diversification is a strategy-dont put all of your eggs in one basketfirm to hold assets and liabilities in several currencies to reduce the impact of unexpected exchange rate changes.

5 D. Risk adaptation

Exchange risk adaptation strategy includes-calls for protecting all liabilities denominated in foreign currency with equal-value, equal-maturity assets denominated in that foreign currencyExample:Assume an Indian firm has contracted to buy $100,000 of machinery from a foreign supplier for use in its manufacturing operations. The purchase is payable in six months in US dollars.Firm may obtain some equal-value dollar asset maturing in 180 days. depositing funds in a dollar-denominated bank account for six months arranging a swap of the dollar liability for some other firms India rupee liability.

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Standard methods of hedging an exposed dollar liability include:

1. Obtaining a dollar-denominated financial asset (e.g., a time deposit or a CD) that matures when the liability comes due.

2. Hedging foreign exchange risks with a forward contract.

3. Finding a buyer for your firms products and agreeing to receive payment in US dollarsfor the same value and time as the liability.

4. Agreeing with a American firm to exchange your dollar liability for their Indian operations rupee liability.

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Economic freedom index

Economic freedom index - rankings

Indias efi

Parameters considered

Implications for companiesCountries with higher EFI scores have had higher rates of Long term economic growth and highest living standardsGovernment control and ownership of FOP decreases the risk affinity of Entrepreneurs and Companies and vice-versaInnovation stimulation in high EFI countriesLess risk of Nationalisation, Adverse Taxation

Uncontrollable / Hand of god risks

List of uncontrollable risksNatural disastersTerrorism

Natural Disasters mitigating riskNatural disasters often lead to lower economic growth and a worsening in fiscal and external balances. They can also have a significant impact on poverty and social welfare.

ways to strengthen disaster risk mitigation and responseIdentify risks and integrate them explicitly into macro frameworks to help determine how much to self insure and how much to spend on mitigating impact;Ensure sufficient fiscal space, and flexibility within fiscal frameworks, to help redeploy spending rapidly;Improve transparency to bring about effective use of disaster assistance and limit contingent liabilities to the state;Strengthen coordination ex post among multilateral institutions, donors, the authorities and civil society organizations, particularly where administrative capacity is limited;Use reconstruction as an opportunity to accelerate broader growth-enhancing structural reforms; andLooking further ahead, explore ideas about how to promote insurance coverage, since insurance penetration reduces the real costs of disasters without raising fiscal burdens

Terrorism the wild cardProtecting employees and corporate assets is the responsibility of operating managers throughout any corporation. In most organizations, few people are fully cognizant of exposures such as kidnapping and extortion. But terrorism, crime, and political instability risks are facts of life, and corporate leaders must deal with them in transacting business in our increasingly global economy

Current Risks Of particular concern to multinationalsLeftist guerrillas who kidnap foreign corporate employees in rural Colombia and in neighbouring Ecuador and Venezuela. Criminal gangs that target executives in Mexico, Guatemala, El Salvador, Honduras, Haiti, Brazil, and elsewhere in Latin America.Tribal gangs that attack multinationals and kidnap their personnel in Nigerias oil-rich Niger Delta. Aggressive, organized-crime groups that run protection rackets in Russia, other parts of the former Soviet Union, and eastern Europe. Vendors, distributors, and joint-venture partners who threaten and even employ violence to resolve business disputes in Russia, China, and other countries with primitive judicial systems. Islamic zealots who target foreigners and foreign business interests as part of their jihad.

Companys responseWell-managed corporations respond by: (1) carefully analysing risks and weighing them against potential rewards of a particular project; (2) fully informing employees of the hazards they face; (3) supplying the wherewithal to enhance their safety through training, technical means such as armoured cars and, in some cases, protective details; and (4) planning the companys response in the event of a kidnapping or an extortion.

A crisis management teamCompanys core crisis management team should consist of at least three individuals: The ultimate decision makerthe CEO or his or her designee; The coordinator, often the corporate security director, risk manager, or chief of international operations; and The general counsel. The team also might include: A finance officer (to arrange for the ransom); A human resources specialist (to oversee the care of a hostages family); and A public relations specialist (to handle press inquiries).

Sheet1Same basket of goods in US and IndiaUSIndiaPPP Exchange rateYear 1200 $20000 INR1$=100 INRIn India an inflation of 10% Year 2200 $22000 INR1$=110 INR