Sources of Financial Risk & Strategies to Minimise Risk
Financial risk is the possibility of experiencing monetary loss of an outcome different from the expected one, due to various factors related to finances and investment.
Non-Payment of Monies
When an overseas buyer fails to pay for goods or services as agreed. Puts the exporter at risk of supplying the goods and failing to be paid.
Takes time and money for the business to manufacture, process and transit the goods to the other country, so the goods may arrive at their destination but not be pain on time.
Reasons for a foreign customer not paying for goods received my be political instability affecting the buyer’s ability/willingness to accept the goods, declined economic conditions of the country or business no longer financially stable, product took longer than expected and is no longer required, currency fluctuations leading to the goods becoming more expensive than anticipated.
This impacts the Aus business’ cash flow and leaves the business at a financial loss for the transaction as they will need to pay extra costs to transit the product back to Aus or navigate the different legal systems and laws to recover the costs incurred.
Exporters might face challenges in enforcing payment through legal means if there are unfavourable laws or difficulty in accessing local legal systems in the buyer’s country.
Currency Fluctuations
Changes that occur in the value of one currency relative to another country’s currency. Puts the exporter at risk of losing money with changes to the dollar value.
If the customer’s country’s currency depreciates against appreciating AUD, the product may be too expensive and cost more than expected, leading to the customer no longer wanting it.
If AUD depreciates, the business will have to pay more for imported raw materials, reducing their profit margins.
Currency fluctuations are influenced by economic factors, political and legal factors.
HEDGING used to minimise risk.
Loss / Damage in Transit
When exporting goods there is a risk of them becoming lost or damaged in transit due to large distances for goods to travel, multiple forms of travel used, passes through multiple hands, natural elements, political unrest.
Hedging
Used to minimise financial risk from currency fluctuations - using agreed currency values in international financial transactions.
If actual currency values change between the time ordered and the delivery, the agreed value is used to calculate payment.
Forward hedging - binding agreement to exchange a currency at a fixed rate on a future date. Rate and date are fixed, with no flexibility. No upfront costs are required.
Option hedging - gives the buyer the ability but not obliged to use a set rate or change the currency value to suit the current market when making the payment. Doesn’t eliminate all risk but adds stability, improves budgeting, and helps the business remain competitive in global markets.
Insurance
Sharing financial risk with an insurance company.
An exporter/importer pays a premium to an insurance company for the service of covering a risk such as non-payment of monies, loss in transit, or loss due to currency fluctuations. The insurance company agree to pay out the agreed amount if the exporter/importer suffers a financial loss due to the agreed scenarios.
If the loss doesn’t occur, the insurance company retains the premium fees paid.
The premium charged depends on the insurance company’s financial risk assessment, but a business can reduce its premium charge if they agree to an ‘excess’ charge payable when lodging the claim.
Can protect cash flow and makes international trade safer, so can take advantage of opportunities overseas.
Insurance contracts are customisable to cover the specific concerns of the businesses.
Premium paid may be expensive if financial risk is high.
Claims are not usually paid out straight away as the insurance company usually investigates the reason for the financial loss to ensure it is covered by the policy.
Documentation
Process used to minimise the risk of non-payment of monies in international businesses.
1) Letters of Credit - document from the importers bank which guarantees payment to the exporter. The seller receives payment once they’ve fulfilled the transaction and submitted all required documents as evidence that match the terms set out in the Letter of Credit.
Since the bank is responsible for paying, the seller has strong protection against non-payment, even if the buyer defaults.
Involves higher costs and requires strict compliance with all conditions of the Letter of credit, so typically used in high-value or high-risk transactions.
2) Documents Against Payment
Process where the buyer can only receive ownership documents to collect the goods after payment has been made. The exporter sends the shipping documents to a bank, which then holds them until the buyer makes full payment. The buyer must pay before receiving the documents which are needed to claim the goods from customs.
Offers some protection to the seller because the buyer cannot access the goods until payment is made, so commonly used when the seller has some level of trust in the buyer and the transaction is considered to carry moderate risk.
Simpler and less expensive method of securing payment.
No bank guarantee, so if the buyer refuses to pay, the seller is still left with the cost of storing, returning, or reselling the goods.