Risks Associated with Foreign Trade

Foreign Trade Risks

Why is foreign exchange risk so important today? there are three broad reasons:

i. The growth in international trade and financing.

ii. The increased magnitude of exchange rate fluctuations.

iii. The increasing visibility of the foreign exchange gains/loss items in corporate financial statement. The first two factors are the source of the foreign exchange risk problem; the third factor helps to explain why the problem is becoming increasingly for corporate financial managements.

Foreign exchange management consists of managing the various types of risks associated with foreign exchange and money market transactions. The main risks are:

a. Exchange rate risk
b. Interest rate risk
c. Credit risk
d. Liquidity risk
e. Country risk

Exchange Rate Risk

(a) The exchange rate risk arises from the net exchange position in a given currency. A net exchange position results from an imbalance between all the assets and purchases of a currency on the one hand, and all the liabilities and sales of that currency on the other hand. This imbalance is unaffected by maturity dates.

 If the assets and purchases of a currency exceed the liabilities and sales of that currency, this imbalance is termed as a "long" or "overbought" position; while if the liabilities and sales of the currency exceed the assets and purchases of that currency, the imbalance is termed as a "short" or oversold" position.

 If the net exchange position is "long" or "overbought" and there is a depreciation of the currency, a loss will occur; while there will be a gain if an appreciations of that currency occurs. the opposite result will accrue if the net exchange position were "short" or "oversold". Accordingly, we find that it is risky to maintain a net exchange position in any foreign currency and hence the need for foreign exchange position management.

Interest Rate Risk

(b) Interest rate risk arises when the maturities of the normally market placements and borrowings do not match. for example, if funds are lent for six months at a fixed interest rate, on the basis of a three-month deposit, at the end of the three months, the deposit has to be repaid and funded by a fresh deposit which would have to be accepted at a higher or lower prevailing rate of interest than the first three-month deposit. The funds manager made the mismatch of six-months loan against a three -months deposit probably in the hope that the interest rate would decline after the first three months. if that hope materialized, the re-financing at the lower interest rate would increase the profit, but should the interest rate rise, the re-financing at the higher rate would reduce or wipe out the profit on the lending transaction. Accordingly, there is need to monitor and control miss-match in maturities through appropriate gap-management.

Credit Risk

(c) The credit risk relates to the counter-party with whom a forward purchase or sale is contracted, to fulfill his obligation to pay or to deliver currency at maturity. in the foreign exchange market, two types of risk could arise, the 10 percent risk and the 100 percent risk. The impact of the failure of the counter-party to meet his commitment depends on whether it occurs before value date or on the same value date of the foreign exchange contract. If the default (inability) is found before the value date the dealer who, expecting inflow or foreign currency, had committed an outflow, should be able to obtain these funds at prevailing market rate. such a risk is traditionally known as 10% risk.

The first type, which is less serious, markets some dealer call it 20% risk. The first type , which is less serious, occurs when the counter-party is unable to deliver the foreign currency at maturity under a forward contract, in which case, the contract will have to be closed by an appropriate sale or purchase in the spot market, resulting in a gain or loss depending on the then prevailing spot rate vis-à-vis the contracted rate.

The second type, which is considerably serious, occurs when the counter-party suddenly fails on the day of maturity of the contract, when one side of the transaction has been completed by one party on account of time difference or automated payment system, while the counter-party fails to complete its part of the deal due to bankruptcy. Accordingly through appropriate credit assessment procedure ,the credit risk and country risk can be managed.

Liquidity Risk

(d) The liquidity risk arises when cash when cash flow in a transaction are not “square”. Such a risk may also occur due to inability to arrange funds when a cash inflow has not been pre-arranged. The liquidity risk, which is connected with the interest rate risk, occurs when a mis match of maturities results in uneven cash flows. the bank may then be unable to raise funds, in the desired currency, at the right time, to meet its financial commitments in the absence of a pre-arranged cash inflow. The liquidity risk may fall in one of the following situations:

(i) Net exchange position; if currencies held are not easily marketable and large amount maturities fall on a given day.

(ii) Swap exchange position; due to mismatched maturities and failure of interest rate movement in the expected direction.

To minimize this liquidity risk and also to minimize loss of income through inadvertently keeping idle balances or inadvertently over-drawing on nostro accounts with foreign branches or correspondents there is the need for cash management.
(e) In determining the country risk for any international lending credit analysis process is a big task. bank with major foreign trade must understand foreign country’s history, forecast its future economic performance, and monitor its internal political and structural changes and how those countries are affected by changes in world economy.

Country Risk

Country-risk can be evaluated the same way as domestic credit-risk to distinguish between acceptable and un acceptable borrowers. The analysis should break down the country’s request for credit into four questions that are analogous to those raised with any borrower: is the borrower willing to repay? what is the use of the funds? what is the primary source of repayments? what is the secondary source of repayment?

A debtor country’s willingness to repay has a lot to do with its domestic discipline in managing its industrial/economic growth.

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