International Finance: Transaction Risk

Transaction Risk

• Transaction risk is the potential impact of exchange rate changes on a company's international transactions.
• Hedging can reduce foreign exchange risk but cannot eliminate it entirely due to market fluctuations.
• Exports become more expensive for foreign buyers when a country's currency appreciates.

Translation Risk

• Translation risk involves changes in an international company's book value due to exchange rate fluctuations.
• Translation risk primarily affects businesses with foreign assets or financial statements.
• A company's book value can be affected by exchange rate changes even if its operations remain the same.

Convertibility Risk

• Convertibility risk arises when a currency cannot be exchanged for another currency.
• Governments may impose restrictions that prevent their currency from being exchanged internationally.
• A currency's value depends on the confidence others have in its ability to be exchanged for goods and services.

Legal Risk

• Legal risk stems from the potential that a foreign legal system will not recognize or enforce agreements.
• A country's legal infrastructure and cultural norms impact legal risk
• Weaker legal systems and negative cultural attitudes increase legal risk for foreign investors.

Settlement Risk

• Settlement risk occurs when one party in a transaction fulfills the obligation, but the other party does not.
• Settlement risk is a type of legal risk because enforcing contracts across international borders can be problematic.

Risk-Free Assets

• Treasury bills are considered risk-free assets.
• Risk-free assets offer low returns compared to riskier investments like equities.
• Risk-free assets include short-term government debt instruments.

Insurance

• The primary purpose of insurance is to distribute the risk of loss among a larger group.
• Insurance companies profit by collecting more in premiums than they pay out in losses.
• Insurance helps distribute risk of loss by pooling funds from individuals or organizations to cover potential damages or losses.

Futures

• Futures contracts limit transaction risk by setting a future price for goods.
• Futures contracts can be employed with world currencies to reduce exchange rate risks.
• Liquidity refers to how easily an asset can be converted into cash.
• Futures contracts are useful in quick transactions due to liquidity

Forwards

• Futures contracts are standardized and easily traded.
• Forwards contracts are customized, and not traded on exchanges.
• Forwards are commonly used in international trade to manage transaction risk and exchange rate volatility.
• Forwards offer customizable terms between two parties for price, quantity, delivery date, and currency without exchange trading.

Options

• A call option gives the holder the right to purchase an asset at a predetermined price.
• A put option allows the holder to sell an asset at a predetermined price as long as it is exercised before the expiration date.
• This type of option allows the holder to benefit from an increase in the price of an asset or a favorable exchange rate using a predetermined price: call option.

Foreign Exchange Swaps

• Organizations use foreign exchange swaps to maintain a reserve of foreign currency for operational needs during temporary shortages of funds.
• Forex Swaps reduce risks related to currency loss in global trade, such as transaction risk and political risk.
• These swaps manage risks like inconvertibility, translation, and transaction risks.

Barters

• Barter transactions' key advantage is avoiding risks related to currency exchange and inconvertibility.
• Barter exchanges trade goods or services directly without currency.
• International Reciprocal Trade Association (IRTA) governs international barter systems.
• Barter systems were once widely used due to tax advantages, until governments taxed barter exchanges.
• Barter exchanges help avoid transaction risk but can create challenges in determining the value of exchanged goods.

Partnerships and Joint Ventures

• A benefit of entering into a foreign partnership is greater involvement in foreign markets and culture.
• Partnerships in global economics do not typically involve full integration with other foreign organizations.
• Partnerships are a business arrangement where two or more parties share ownership of a non-incorporated organization, frequently with one partner residing in another nation.

Mergers and Acquisitions

• Expanding through mergers and acquisitions reduces risk compared to starting a new company from scratch.
• Mergers and acquisitions involve one company purchasing another, giving the purchasing company full control.
• Mergers and acquisitions are not usually only performed by small companies in the international business context.

Wholly Foreign Owned Enterprise

• Wholly Foreign-Owned Enterprises (WFOE) give greater control and strategic consistency compared to partnerships or mergers.
• WFOEs are companies located in one nation entirely owned by an organization, individual, or partners from another nation, without local ownership.
• A WFOE does not share ownership and control with foreign entities in the host nation.

Financial Investment

• A primary form of financial investment is equity.
• "Equities" are shares of ownership in an organization, commonly known as stocks
• Debt investments are not purchased to gain dividends.

International Diversification

• International diversification reduces market risk and the impact of national economic fluctuations.
• Guarantees a risk-free return is not a benefit of international diversification
• Diversification does not eliminate all risks associated with poor investment decisions

Eurobonds

• Eurobonds are denominated in a currency other than the issuing nation's primary currency.
• Eurobonds allow organizations to minimize exchange rate fluctuations and avoid transaction risk.
• A Eurobond denominated in Japanese yen is called a Euroyen bond.

Sourcing Capital Globally

• Euroequity Issues are the most integrated and difficult method of sourcing capital globally.
• Cross-listing allows a company to make its stock available in multiple nations' stock markets without affecting the domestic share price.
• The first step in expanding a company’s stock market potential in foreign markets is cross-listing.

International Portfolio Optimization

• The nation an investor chooses significantly affects international portfolio optimization.
• Increasing investment options does not increase the potential for higher return.
• In international investing, it's assumed that successful companies in developing nations will have amazing futures.

Global Cost of Capital

• A primary benefit when raising capital internationally is decreasing the cost due to a broader investor market.
• The trade-off when raising capital internationally for higher-budget projects involves higher costs and the need for careful management of the return on investment.
• Raising capital internationally does not always result in lower costs.

Trade Gravity

• "Trade gravity" focuses on trade and economic activity flowing to regions with higher economic density.
• Trade gravity is related to GDP which reflects the economic activity of the city or region.
• Trade gravity is not influenced only by the distance between locations and ignores economic mass.

Industrialization

• Natural resources are the primary source material for industrialization.
• Industrialization is the process by which physical capital assets are drawn to industrialized areas to increase production and development.
• Tertiary goods refer to services and are necessary for development, not basic survival

Urbanization

• Better wages and working conditions are the primary factors attracting people to urban areas.
• Urbanization is the process by which people are attracted to concentrated regions due to the availability of work opportunities.
• High-density urbanization has people living closely together, such as in apartments or lofts in cities.

Urban Sprawl and Decay

• Single-purpose zoning and low-density occupation are key features of urban sprawl.
• Urban decay occurs when people and resources move away from a city and results in a decrease in value and production potential.
• Urban sprawl describes the geographic expansion of a metropolitan area into previously rural or agricultural land.

International Migration

• International migration describes the movement of people from lower-income nations to higher-income nations.
• Migrants leave their home nation to live in another.
• Expatriates don't necessarily come from less developed nations.
• Illegal migration is people moving countries for better economic opportunities and resulting in a black market labor source.

Capital Flight

• Capital flight is the rapid or systematic outflow of capital from a nation.
• It is not just the movement of physical assets but includes money.
• Capital flight is a process which businesses and investors move their capital out due to economic opportunity in another location.

Brain Drain

• Brain drain is the departure of highly educated or skilled individuals due to a lack of opportunities.
• Its consequence includes lower levels of development, innovation, and decreased international competitiveness.
• Brain drain does not refer to the movement of unskilled workers seeking better opportunities.

Involuntary Integration

• Involuntary integration includes the illegal drug trade that operates across borders.
• It describes economic processes that occur despite government efforts to regulate or restrict them.
• Involuntary integration is the the process of economic integration that happens without government control or voluntary agreements.

Urban Renewal

• Urban renewal aims to attract investments, make cities desirable, and ensure economic sustainability.
• Urban renewal efforts should begin early, while a city is still generating enough revenue to invest.
• Urban renewal refers to re-establishing growth and development in a previously decayed urban area.

Growth

• Economic growth refers to the total change in a nation's production.
• Gross Domestic Product (GDP) measures the value of all output produced within a nation's borders.
• GDP is the primary measure used to calculate the growth of a nation’s economy.

Development

• Growth concentrates on the total value of production.
• Development focuses on the quality of life.
• The Human Development Index (HDI) takes into account health, wealth, and education to measure development.
• Quality of Life Index (QLI) includes life expectancy, divorce rate, and gender equality.

Income Disparity

• The Gini coefficient measures the distribution of wealth across a population.
• A Gini coefficient of 0 does not indicate a perfectly unequal distribution of income.
• The Lorenz curve illustrates the real national distribution of income and how far it deviates from perfect equality.

Sources of Development

• The number of international corporations within a nation is not directly related to a nation's ability to develop economically.
• Nations with access to natural resources are more likely to experience economic development.
• Surplus production describes when nations increase their wealth by producing excess goods for trade.
• A lack of waterways hinders a nation's development.

Developed and Developing Nations

• Developing nations grow and develop quickly but may struggle with stability.
• The age of a culture does not directly influence a nation's economic development.
• Developed nation is one with a diverisified economy that has been industrialized with manageable growth rate.
• "First-world nation" is an outdated term for developed nations.

Least Developed Nations

• Least-developed nations (LDNs) rely heavily on the extraction of natural resources and subsistence farming.
• They often experience rapid urban decay after temporary industrialization projects funded by foreigners.
• The primary barrier to development in many LDNs is national instability.
• Haiti is an example of a least-developed nation.

The North-South Gap

• The North-South Gap describes the economic divide between developed nations north of the equator and LDNs south of the equator.
• Racial differences and genetics do not cause this gap.
• A lack of resources in the global south hindered them from trade and economic development.
• Genetic differences between populations are not a primary cause of the North-South Gap.