In an environment that is increasingly becoming global, international business is gradually changing into a norm rather than an exception. More businesses and investors are gaining interest in cross-border businesses and investments. Husted and Melvin in their book look at this issue in detail, discussing three important issues, namely, foreign exchange risk, forecasting and international investments.
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Foreign exchange risk
When engaging in any kind of cross border business, investors expose themselves to foreign exchange risks. A foreign exchange risk is the risk which results from unpredictable changes in the foreign exchange rate, making it uncertain to gauge the real value of foreign transactions (Husted & Melvin, 2010, pp. 383).
Every foreign transaction is influenced by the foreign exchange rates. This necessitates the need for forecasting to individuals and firms involved in the international business. There are three kinds of risks in regards to international investors and businesses. These are accounting exposure, transaction exposure and economic exposure.
Accounting exposure otherwise also known as translation exposure, emanates from differences between foreign currencies dominated assets and foreign currencies dominated liabilities. There is always a danger on equity falling if the concerned foreign currency depreciates to the level of the home currency.
Transaction exposure, on the other hand, occurs when there is uncertainty in regards to the domestic currency future value of a transaction dominated by a foreign currency (Wang, 2009, pp. 345). This kind of exposure requires the firms involved to either hedge through forward contracts or face the risks.
The third type of exposure and the most important one to the firm is economic exposure. Economic exposure arises from changes in exchange rates. The level, direction and extent of exchange rate changes are always unstable. This poses uncertainty on the future profitability of business.
There are various ways investors can hedge against foreign exchange risks
and through which investors can protect themselves from over-exposure to foreign exchange risk. They include:
- domesticating foreign transactions,
- either speeding and slowing of making payments when currencies are expected to appreciate and depreciate respectively;
- Options, forwards, and futures markets.
There are some other implications, hedging being one of them. Hedging presents the possibilities of earning what is generally known as a risk premium. A foreign exchange risk premium refers to the difference in rates between the forward and expected future spot rate (Husted & Melvin, 2010, pp. 386).
A risk premium is measured in terms of its effective return differential. Effective return differential of a risk premium refers to the percentage difference between a forward future rate and expected future spot rate.
Whenever this differential yields a positive outcome, there appears a positive risk premium on the domestic currency. If the market is efficient and all the parties involved in making hedging decisions are availed and aware of all the information required to make those decisions, then a forward rate will differ with an expected future rate by only the risk premium.
Foreign exchange forecasting
Hedging decisions as have been described above require some prediction of the future currency outlook. Foreign currency forecasting refers to looking at the future currencies (Goddard & Ajami, 2006, pp.122).
Forecasting errors are always bound to occur but they should be completely minimized or even eliminated. Investors, who are able to make a forecast that is to be closest to the correct actual rate, are able to make more money. The ability to make a forecast rate that is better than the actual rate does not always imply an inefficient market.
Sometimes the interest differentials that exist across countries and the desire to hold diversified portfolios may attract investors into investing in foreign markets. Generally, it is advisable that whenever one decides to invest internationally, they should go for diversified portfolios rather than a single portfolio to reduce vulnerability of variation.
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Diversification of a portfolio does not in any way indicate that investors are able to fully eliminate the risk of investments. Diversification only eliminates nonsystematic risks but also systematic risks which are common across all investment opportunities. It is commonly found out that due to factors, such as taxes, transaction costs, and limited gains from international investments, there exists a home bias where investors prefer domestic securities instead of foreign securities.
Foreign direct investments
With globalization, attractive opportunities, investments, environments coming from emerging economies, a sizeable number of firms are considering setting up foreign operating units in foreign markets. The spending of firms to establish such units is referred to as foreign direct investment.
Some of the reasons behind such kind of investments include economies of scale, technology transfer and the appropriation of foreign markets. Some of the benefits of direct investments as opposed to these different kinds of investments, for example, portfolio investments include
- the insulation to foreign losses and short-term economic changes;
- gains from new technologies and expertise unavailable at home;
- the benefits of investing in actual productive resources.
When a high number of firms opt out a country owing to unfavorable investment conditions, a capital flight may occur. It is, therefore, advisable for the countries to maintain good investments environment to avoid problems with capital flows.
Goddard, G. J. and Ajami, R. A., 2006, International Business: Theory and Practice. 8th ed. M.E. Sharpe, New York.
Husted, S. and Melvin, M., 2010, International Economics. 9th ed., Prentice Hall, London.
Wang, P., 2009, The economics of foreign exchange and global finance. 2nd ed., Springer, New York.