Your business has to manage both local and global risks associated with currency, credit, intellectual property, transportation, ethics and more. But don't worrythere are a number of tools available to limit the effects of these risks on your business.
Businesses engaged in global trade have to deal with not only their local business risks, but also a number of global business development risks associated with currency, credit, intellectual property, transportation, ethics and more. These risks can hinder international business development, but there are tools available to limit the effects of these risks on business.
Foreign exchange risk
Foreign exchange risk usually concerns accounts receivable and payable for contracts that are or soon will be in force. Foreign exchange rates are constantly in flux, so businesses can be forced to convert funds generated abroad at lower rates than they budgeted. That is why it is imperative that businesses have a foreign exchange policy in place to:
- stabilize profit margins on sales
- mitigate the negative impact of exchange rate fluctuations on procurement and sales
- enhance cash flow control
- simplify foreign and domestic pricing
In order to formulate an adequate foreign exchange policy, businesses must assess their foreign exchange risks, identify the tools available to hedge these risks and carry out a regular comparative analysis to select the most effective tools.
Here are the main types of foreign exchange policies:
- Natural hedging: With this type of hedging, the business generates the majority of its revenues and expenses in the same foreign currency but does not hedge the difference between payables and receivables.
- Selective hedging: This type of hedging covers some foreign exchange transactions when it is difficult to predict needs.
- Systematic hedging: This type of hedging covers all foreign exchange transactions to eliminate the impact of foreign exchange fluctuations on profit margin.
Here are the main currency hedging tools:
- Currency forward: A forward contract between 2 parties spells out the conditions for the sale or purchase of a specified amount of currency (rate, date). In some cases the contract can be open-ended or fixed to provide greater flexibility on delivery.
- Swap: In a swap, 2 cross trades are carried out at the same time in equivalent amounts. They are used to match foreign currency inflows and outflows occurring on different dates and to move a currency forward up or back. For example, a swap can be used to immediately purchase an amount in a foreign currency to pay accounts payable in exchange for a currency forward for the resale of currency when receivables are paid. This way any difference between the rates will be from the forward points and will be locked in.
- Vanilla option: A vanilla option is used to transfer the foreign exchange risk to a third party in exchange for a premium. The business reserves the right to purchase a specified amount of currency from the third party on a set date at a pre-determined rate. This way the business makes money if the currency increases in value and is protected if it loses value. The premium is non-refundable.
New option strategies become available as the business expands to new global markets. These tools are used to buy and sell options simultaneously to reduce risk exposure (tunnel, participating forward).
To learn more, see the Managing Foreign Exchange Risk guide (PDF, 547KB).
Credit risk
Credit or counterparty risk is the risk of not collecting an account receivable. There are ways businesses expanding to global markets can protect themselves against this risk.
- Payment in full at the time of order or open account payment: The business wants to receive 100% of the amount owed at the time of the order, before services are rendered. Such an approach can be used to finance operations, cut finance charges and administrative expenses and eliminate the risk of non-payment. It may be difficult for new exporters and businesses with little negotiating leverage to use this method.
- Letter of credit: A letter of credit is a contingent payment commitment issued by a financial institution whereby the institution agrees to pay a set amount to the product or service provider in exchange for the delivery within a set timeframe of documents proving that the goods were shipped or the service was rendered. A letter of credit protects both the buyer and the seller. It includes the terms of sale and a detailed description of the shipment. The funds are set aside and cannot be used by the buyer as long as the letter is in force.
- Standby letter of credit: A standby letter of credit is used to guarantee creditworthiness. It is not intended to be cashed but rather to guarantee payment under a contract.
- Credit insurance: Credit insurance protects the business's export accounts receivable in exchange for a premium. It is widely used to indirectly finance the buyer by giving the business more flexible payment terms.
- Factoring: Factoring is a common transaction wherein some accounts receivable are sold to a third party to transfer some of the risk and to finance operations. For the customer, it's a short-term financing product that can be used to finance foreign or local sales by selling receivables in exchange for immediate cash without having to wait for payments. Factoring is also a solution to certain liquidity problems that often arise as sales grow.
There are additional techniques for limiting credit risk, but these 5 approaches are good options for businesses looking to go global.
Intellectual property risk
Intellectual property risk is the risk that third parties may make unauthorized use of the business's strategic information (studies, research, agreements and contracts, client list, trade secrets, etc.) or property that directly or indirectly affects the value of the business's products or services (patents, designs, trademarks, know-how, etc.). When doing business internationally, these risks increase tenfold because of the difficulty of remotely defending the business's rights to this property.
Businesses should register their corporate names and trademarks before signing any agreement, such as a distribution contract, in any country. That said, it is costly and complicated to register and attempt to defend a patent in some areas of the world where intellectual property rights are unlikely to be respected. In these places, it is better for a business to constantly modify or improve its offer to remain competitive, stay one step ahead of the competition and limit the effect of infringement and counterfeiting.
Shipping risks
Whether shipping goods locally or abroad, you face risks such as breakage, loss, theft, vandalism, accident, seizure and contamination. Before you ship any goods, transfer responsibility for shipping to the buyer or seller and take out sufficient insurance. The International Chamber of Commerce's Incoterms set out each party's roles and responsibilities with regard to shipping risk. It is best to work with a forwarding agent.
Ethics risks
Maintaining high ethical standards and being a good citizen can be a challenge in any market. Operating in global markets can lead some businesses to question their values. They must be especially vigilant because customs and social conditions vary from country to country. Make sure that your foreign partners and suppliers adhere to your ethics rules and values wherever they operate.
Desjardins can help you do business internationally, maintain good relations with your foreign customers and suppliers and manage your business risks. Contact Desjardins International Services
