Risk Management: Foreign Exchange Risks, Credit Risks, Interest Rates Risks

Introduction

Business is a complicated process in which there is a whole net of relations and processes involved. Risk is one of the integral parts of business as a business entity can never be sure about its business partner fulfilling all its obligations according to the agreement they conclude. For dealing with the situations of the kind the risk management has been developed by the specialists in business analysis. The importance of risk analysis and management has been under the great public scrutiny since the world has been shaken by the harshest economic recession for the last several decades (Kidwell, Blackwell, Whidbee, and Peterson, 2008, p. 33). Drawing from this, the current paper will focus on the theoretical considerations of risk management, the categorization of risks involved in the international business activities, and the correlation of risk types discussed with the basic techniques implemented for risk management by the number of reputable international business companies. First, this paper examines the basic characteristics of foreign exchange risks and the credit risks. Next, the major techniques to manage these risks are considered. And finally, the implications of another major risk, i. e. interest rate risk, upon the foreign exchange and credit risks are examined.

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Foreign Exchange Risks

Major Characteristics

The main purposes of the risk analysis procedures that almost every business entity has to carry out to keep track of the market conditions include, as scholars like Behr & Guttler (2007) and Wu (2007) argue, being able to avoid risk or fight the consequences of the risk manifestation timely and properly. The area of business called currency exchange market is especially sensitive to the concept of risk, and therefore risk analysis is of crucial importance for the exchange market players. Theil & Ferguson (2003) argue that foreign exchange risks demand special attention in business because these risks determine the rate of profitability, or loss, that companies might suffer because of the exchange rates fluctuations and changes.

According to Osei-Kuffour (2000), risk in the foreign exchange market is defined on the basis of the very concept of currency exchange (p. 41). Currency exchange, Osei-Kuffour (2000) argues is the manifestation of the numbers of units of a certain currency that can be bought or sold per unit of another currency (p. 42). Therefore, “foreign exchange risk is the risk of loss (or gain) from unforeseen changes in exchange rates” (Osei-Kuffour, 2000, p. 42). The major types of risks of this category include the risk of loss in case of the exchange rate decrease, inability of one of the international business partners to convert the needed amount of money from one currency to another one, problematic situation with the exchange of a certain currency in a certain region, and especially the excessive dependence of the national currency upon the foreign one. The example of Ghana in 1980s illustrates this risk rather vividly, as the country’s currency, cedi, was too dependant on the British pound sterling, and the drastic increase in the latter’s exchange rate caused bankruptcy of numerous enterprises in Ghana and increased poverty levels in the country (Osei-Kuffour, 2000, p. 42).

Risk Management Techniques

The main techniques that help organizations deal with the foreign exchange risks include the forward market hedging and currency futures (Barrese & Scordis, 2003, p. 26). Thus, forward market hedge is, simply to put it, the opportunity for business entities to predict potential foreign currency rates’ changes and stipulate the duties of both contracting parties in a forward hedging contract. The example of the usefulness of this risk management tool is presented by Osei-Kuffour (2000) who considers the German – Nigerian transaction in which the German company pays in Deutsche marks for the transaction but the Nigerian company demand US dollar payment, and only the forward hedging contract protects both sides from financial issues connected with potential shifts in Deutsche mark-US dollar exchange rate (p. 41). Without the forward hedging contract, the Nigerian company might lose considerable share of its profit if Deutsche mark-US dollar exchange rate would rise, while the German company might suffer losses associated with the increase of dollar value (Bartolini, 2002, p. 11).

The currency futures technique is similar to the forward hedging contract in its ability to protect business entities from the potential shifts in currency exchange rates. According to Cummins & Rubio-Misas (2006), the currency futures contract enable the contracting parties to buy certain amounts of foreign currency at the fixed rates or purchase goods at the currently fixed exchange rates, although the actual payment might take place later (p. 323). Under the currency futures contract, the payment in such a situation is carried out according to the exchange rate fixed in the futures agreement (Osei-Kuffour, 2000, p. 42). Through both forward hedging and currency futures contracts, business companies might protect their interests from the foreign exchange risks.

Credit Risks

Major Characteristics

Another important type of risk in business is the credit risk. As defined by Wong (2003), “credit risk concerns the inability of a counter party to fulfill its obligations” (p. 46). From such a definition, credit risk can obviously be considered as a product of the improper relations of the contracting parties in various regions of the world, as under the conditions of complete fulfillment of all contractual obligations by all partners, there would be no such a phenomenon as credit risk. However, Wong (2003) goes further to assume that the credit risk can also be a backfire of the improperly implemented forward hedging contracts as means of fighting another risk, i. e. the foreign exchange risk (p. 46). This assumption is also explained by the impossibility of the complete fulfillment of all contractual obligations by business entities. According to Wong (2003), as well as to Barrese (2003), credit risks mainly emerge as a result of either inability or reluctance of one contractual party to fulfill its obligations towards another one (Wong, 2003, p. 46; Barrese, 2003, p. 11).

As well, Wong (2003) exemplifies his argument with the situation that happened in Russia in 1998. The dominant financial market player in the country, the company Long Term Capital Management (LTCM) experienced a collapse caused by the drastic increase of exchange rates and interest rates in Russia. This resulted in the country-wide credit crisis caused by the fact that most businesses and private persons had taken loans in foreign currency and became unable to pay them off because of the increased exchange rates (Wong, 2003, p. 46). Thus, credit risk is even a more serious issue than the foreign exchange risk, and it demand proper techniques for its management.

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Risk Management Techniques

The major techniques used for the management of the credit risks include the credit risk measuring and the so-called “net settlement” as argued by Banham (2004, p. 65) and Kahn, McAndrews, & Roberds (2003, p. 591). The former technique, i. e. risk measuring, is a basic policy for any business entity as it allows this entity to be perfectly, or at least approximately, prepared for the potential risks and to develop the strategies to face those risks. Banham (2004) argues that banks, as the business entities that face the credit risks most often, start implementing such a risk management technique as risk measuring from the very beginning of their development (p. 65). It is a natural banking practice to carry out the interest rate projections for certain periods of time in the future. Banks, especially commercial ones, also resort to the almost obligatory practice of checking the credit history of every applicant, whether a private person or an organization, for a loan from this bank (Banham, 2004, p. 65).

Therefore, analyzing the data obtained from all the above techniques, business entities can measure potential risks and handle them accordingly. One of other ways to manage the credit risks is the net settlement, which, according to McAndrews, & Roberds (2003), presupposes the existence of the net counterparty, i. e. a bank which is not involved in business relations with any other banks (p. 591). Minimum capital requirements are set under the net settlement technique, and every bank has to transmit the established capital requirement to the specified counterparty bank, which allows for adequate fulfillment of credit obligations and centralized control over it (Willmott, 2009).

Interest Rates Risks

Implications for Foreign Exchange Risks

Needless to say, interest rate risk is also involved in the consideration of the foreign exchange risks. Kiff, Kodres, Klueh, and Mills (2008) argue that foreing exchange operations might often be complicated by the impossibility or difficulty in changing certain currency in a certain region. For example, in China both euro and US dollar are acceptable, while it is difficult to exchange Chinese Yuans in Europe. Therefore, the financial institutions that deal with such operations establish the interest rate for which they are ready to carry out such risky foreign exchange operations that cannot be easily carried out in other locations (Holmstrom & Tirole, 2000, p. 295). This way, interest rates for the risky operations help at least partly cover the potential losses associated with the foreign exchange operations, especially in the currently instable and stagnating market.

Implications for Credit Risks

The implications of the interest rate risks for the management of the credit risks cannot be overestimated. For example, Cragg (2003) argues that interest rates are the tool that banks can use to maximize the inutility of their resources and protect themselves from the credit risks (p. 58). In other words, establishing the interest rates for the loans a bank makes, this bank tries to cover the potential losses that might occur if the borrowers fail to fulfill their contractual obligations and the credit risks become real for this bank (Honohan, 2008, p. 15). At the same time, Carrieri & Majerbi (2006) claim that interest rates can themselves be associated with risks for financial and business institutions (p. 372). This is true especially for the organizations implementing the net settlement technique of managing the credit risks, as the increased interest rates designed to protect the organization from credit risks might become the caused for the increase of the minimum capital requirements for this particular organization.

Conclusions

So, concluding this paper it is necessary to restate that risk is an integral part of any kind of business activity. However, only the recently observed global economic recession has managed to attract considerable public attention to the problem of business risk and the ways of its timely forecasting, measuring, and management. In the current economic conditions, the business entities all over the world are concerned with developing the efficient risk management techniques for handling the two specific areas of risk, i. e. foreign exchange risks and credit risks.

The foreign exchange risks are so critically important to consider as the ability of business entities to manage them determine the rate of success for various branches of international business. The foreign exchange risks are mainly associated with the fluctuations of exchange rates for various currencies and the potential losses these fluctuations might cause to business organizations. The foreign exchange risks are best managed through forward market hedging and currency futures that provide the protection for the interests of both contracting parties for the cases when the exchange rates of certain currencies change when their transactions are in progress.

The credit risks are associated mainly with the global economic recession and the inability of contracting parties to fulfill their contractual obligations under the current economic conditions. The leading management techniques for these risks include credit risk measuring and net settlement. Interest rates risks have implications on both foreign exchange risks and credit risks, as interest rates risks can be both the protective means from the above risks or the catalysts for their further development.

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Reference

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