RISK ANALYSIS IN FOREIGN TRANSACTIONSFor any firm operating on an international level or on domestic there is always the concern of the risk posed by direct or indirect currency exposure. In one way or the other and every firm in the market is affected by drastic fluctuations of currency. The only option there is for these firms is to reduce the risk or eliminate it all together depending on the capacity level (Papaioannou, 2006). This is what analysts refer to as hedging. It is a daunting and complex task considering the amount of data that needs to be collected and the complexities involved in correct measuring of the current risks exposure and decide on the correct strategy to be adopted to counter the risk (Papaioannou, 2006).
The sources of foreign exchange risks in a business can arise from different transactions depending on the level of operation for example where the business imports or exports, where other costs such as capital expenditure is denominated in foreign currency, where income for exports is received in foreign currency, where business loans are denominated in foreign currency and have to be paid in the same (Dominguez & Tesar, 2001).
These and other factors make it important for a business to continually analyze the risk aspect facing the business in terms of foreign exchange. This paper is particularly interested in discussing exhaustively the major objectives of a business in analyzing foreign exchange risks and the popular techniques used in analyzing foreign exchange risk. As such the paper is structured into these two sectionsForeign exchange risk analysis objectivesTax objectives- When a business protects against fluctuating currency, it reduces the volatility of the pre-tax value of the company.
The effect of this is that it decreases the expected tax from the company and as such increases the expected post tax value of the business. This is very beneficial to the business in terms of maintaining a healthy balance sheet that is an important tool whenever the business is looking for internal or external funding. If insured, the insurance can be able to cover the risk of having the revenue eaten away by losses in the taxable income (Popov & Stutzmann, 2003).
Protecting against financial distress- A firm should at any cost avoid financial distress as it the worst thing that can happen to any business that in a competitive market. Financial distress is majorly caused by lack of prudent financial management for example borrowing more than the company can afford to pay. In this case however it can be caused by an unprecedented fluctuation in foreign currency (Allayannis, Brown & Klapper, 2002). Hedging reduces the expected cost of financial distress and raises the expected income to the company’s claimholders.
Consequently the reduction in financial instability in the firm will increase the expected value of the firm. Sticking to the company’s investment policy- While it is possible to get external funding to run a company and take care of expansion plans, the external source of funding is expensive as compared to the internal funding. A company is therefore expected to only result to external funding only when the internal sources of finance are not capable of supplying the expected amount. As such the company should do everything to reduce volatility of its cash flow.
One way of doing this is having a hedging plan that will measure the risk in currency fluctuations and mitigate against its effects on the company’s cash flow (Allan, 2003).