The Economic and Financial Environment of International Business Dr. Joshua Shackman Trident University

Overview Global financial managers need to worry about numerous factors that financial managers in domestic-only firms don’t need to worry about Multinational firms must do business in multiple currencies in multiple economies, often in unstable parts of the world In this presentation we will discuss some of the options global financial managers have to deal with these risks

Managing Currency Risk Suppose you receive one million Euros per month in revenues from your European division. At current exchange rates one Euro is worth 1.38 U.S. dollars. So this means you are making $1,380,000 per month. But what happens if there is another financial crisis in Europe and the exchange rate changes from 1:1.38 to 1:1 with the Euro losing value? Now your revenues will be dropping to $1,000,000 per month even though your sales have not dropped at all!

Managing Currency Risks, cont. As shown in the slide before, as exchange rates change your revenues can change even if your sales and operations remain exactly the same. Exchange rates may change everyday So what’s a financial manager to do? Luckily there are tools to deal with this risk

Hedging One method of dealing with exchange rate risk is called hedging. This is a form of insurance in case exchange rates change in a way that is unfavorable to you. There are marketplaces where the company can place “bets” on the direction of the currency. Instruments that you can use include currency options and futures.

Hedging, cont. Going back to our previous example, suppose you want to insure your $1,380,000 month revenue stream no matter what the Euro exchange rate is. You can buy something called a “put option” which is a bet that the Euro will lose value. If the “strike price” of a put option is $1.38 per Euro, you are betting that the value of a Euro will drop below $1.38 U.S. dollars in the future.

Hedging, cont. If the exchange rate drops from $1.38 per Euro to $1 per Euro, your profit on this bet will be 38 cents for each put option that you purchased So if you purchased one million put options, your profit would be $0.38*1,000,000 = $380,000. So while your revenues would drop from $1,380,000 to $1,000,000 - you also gained $380,000 from betting that the exchange rate would fall. So with a hedge if the exchange rate stays the same or goes up, your revenue stays the same or goes up. But if the exchange rate goes down, your revenues stay the same.

Advantages/Disadvantages of Hedging Main advantage is that it insures a steady stream of revenues, the company won’t be impacted by an unfavorable change in exchange rates Disadvantage is that hedging isn’t free, purchasing options or futures can be costly. Options and futures are traded on the exchanges, and the price depends on market conditions

To Hedge or Not to Hedge? Over the long run exchange rates tend to balance out, they go up sometimes and go down sometimes. Over the long run the firm will make more money if you don’t hedge as you avoid the costs of options or futures. But of course there is no long run if you don’t survive in the short-run. Some hedging is usually necessary to protect you from a major currency shock or crisis.

Alternatives to Hedging One method is to do business in multiple countries. If an exchange rate changes unfavorably in one country, it may change favorably in another If your production capabilities are flexible, you can move operations into a country when their exchange rate drops. You can take advantage of cheaper production costs that results from the change in exchange rates. An example of a change in production costs – suppose the exchange rate is 50 Indian rupees to one U.S. dollar. The value of the rupee drops to 100 rupees to one dollar. This means it cost Indian consumers twice as much to purchase products from the U.S. However, it also means that costs of labor and raw materials will cost half as much as they used to for U.S. companies. So in this case if operations are flexible it might be wise to expand production operations in India based on this change in exchange rates.

Alternatives to Hedging, cont. If your marketing is flexible, you can expand marketing operations in a country when their exchange rate increases. You can take advantage of the increased revenue you can make off of a more valuable currency in this case. To expand our example from the last slide, suppose the Indian rupee increases in value from 50 rupees for one dollar to 25 rupees for one dollar. Thus Indian consumers will have doubled their purchasing power for U.S. made products. A U.S. made product that costs $10 would have previously costs 500 rupees. But with the new exchange rate the product would now only cost 250 rupees. Given the ability of Indian consumers to purchase U.S. made products at less cost to them, if marketing is flexible it may make sense to take advantage of this exchange rate and begin marketing and advertising more in India.

Other Risks Political risks – can be extreme. Wars can cause your company to leave the country. Unfriendly governments can seize your business. Like hedging, it may be possible to purchase forms of political risk insurance. There are also ways to protect against political risk besides insurance, such as adopting practices that make your business more popular to the local government and local population

Other risks, cont. Economic risks – inflation can go out of control in some countries, or the economy can go into a severe recession. The banking system in a country can also collapse One example is Greece – once thought of as a stable European economy using the normally stable Euro currency their economy is now in ruins

Concluding Comments As you can see, there are many types of risks to consider. Global financial managers have a lot to worry about, but also strategic tools to use In general, these tools include both formal insurance or hedging instruments as well as changing your operations or strategy This presentation has touched upon some of the main issues, but read up on more financial risk management strategies in the background materials for more detail and specifics.