Risk and Insurance in nepal and risk management in international business

risk management in international business

1. Unit – VIII Risk Management in International Business BBA – VI Nepal College of Management (NCM)

2. Concept of Risk and Managing Risk Risk, in a general sense, refers to the probability or likelihood of an event or situation leading to adverse consequences It includes the uncertainty and variability associated with potential outcomes, especially those that may have negative impacts on objectives, goals, or values Managing risk is a systematic process of identifying, assessing, prioritizing, and mitigating risks to an organization in order to minimize the negative impact on its objectives and operations

3. Reasons to Manage Risk Risk management is essential for corporations due to various factors that can impact their operations, financial stability, and long-term success Financial Stability Effective risk management helps maintain financial stability by identifying and mitigating potential threats to the corporation's financial health This includes risks related to market fluctuations, credit, liquidity, and other financial factors

4. Reasons to Manage Risk Shareholders’ Value Enhancement Managing risk is directly tied to protecting and enhancing shareholder value By minimizing the impact of adverse events, corporations can preserve and potentially increase the value of their shares Compliance and Governance Corporations are subject to various regulations and governance standards Risk management ensures compliance with these requirements, reducing the likelihood of legal issues, regulatory fines, and damage to the company's reputation

5. Reasons to Manage Risk Strategic Planning and Decision-Making Risk management is integral to strategic planning and decision-making processes It enables corporate leaders to make informed decisions by considering potential risks and uncertainties, aligning actions with overall business objectives Operational Continuity Managing operational risks helps ensure the continuity of business operations Corporations can identify and address potential disruptions to their supply chain, production processes, or service delivery, minimizing downtime and losses

6. Reasons to Manage Risk Supply Chain Flexibility Global corporations often rely on complex supply chains Managing risks in the supply chain helps mitigate disruptions due to events such as natural disasters, geopolitical issues, or supplier failures, ensuring a consistent flow of goods and services Innovation and Growth To foster innovation and pursue growth opportunities, corporations need to take calculated risks However, managing these risks ensures that the organization can innovate strategically without risking its overall stability and financial well-being

7. Risk Management Approaches Risk Avoidance Diversification Risk Transfer via Insurance and Derivative Securities Risk Sharing

8. SWAPS and FUTURES for Managing Risk Hedging is a risk management strategy used to minimize or offset the impact of potential financial losses by taking a position in a related or correlated financial instrument This strategy is commonly employed to protect against adverse price movements in various markets, such as commodities, currencies, stocks, or interest rates The goal of hedging is to reduce uncertainty and stabilize financial performance

9. SWAPS and FUTURES for Managing Risk Swaps are a recent innovation; they were first introduced to the public in 1981 when IBM and the World Bank entered into a swap agreement A swap is an agreement by two parties to exchange, or swap, specified cash flows at specified intervals in the future The term "swap" refers to a financial transaction between two parties who agree to exchange cash flows or other financial instruments over a specified period In practice, most swap contracts fall into one of three basic categories: currency swaps, interest rate swaps, and commodity swaps

10. SWAPS and FUTURES for Managing Risk Currency SWAP It is most often used when companies make cross-boarder capital investment Counterparties exchange the principal amount and interest payments denominated in different currencies These contracts swaps are often used to hedge another investment position against currency exchange rate fluctuations Currency swap requires the principal to be specified in each of the two currencies The principal amounts in each currency are usually exchanges at the beginning and at the end of the life of the swap Usually the principal amount are chose to be approximately equivalent using the exchange rate at the swap’s initiation

11. SWAPS and FUTURES for Managing Risk Example CG Ltd. is a Nepali Company having a subsidiary in US and is looking to raise $10,000 for funding its subsidiary for 1 year and interest is paid at the end of year. It can borrow at the following rates: Dollar at 8% and Rupees at 12% CB Ltd. is US based company having a subsidiary in Nepal and is looking to raise Rs.12,00,000 for funding its subsidiary for 1 year and interest is paid at the end of year. It can borrow at the following fixed rates: Dollar at 6% and Rupees at 15% The current spot rate is $1 = Rs.120

12. SWAPS and FUTURES for Managing Risk CG Ltd. (Nepal) CB Ltd. (US) CG Ltd.’s Subsidiary in US CB Ltd.’s Subsidiary in Nepal Required Fund $10,000 Required Fund Rs.12,00,000 CB borrows $10,000 and gives to CG’s subsidiary CG borrows Rs.12,00,000 and gives to CB’s subsidiary

13. SWAPS and FUTURES for Managing Risk At the beginning both companies have exchanged (swapped) their principal amount At the end of year (i.e. at interest payment date) CG pays interest on its borrowing and CB pays interest on its borrowing in respective banks At the same time, CG collects the same amount of interest and principal from subsidiary of CB and repays the principal amount of loan Same process will be followed by CB company in US

14. SWAPS and FUTURES for Managing Risk Interest Rate SWAP Counterparties agree to exchange one stream of future interest payments for another, based on a predetermined notional principal amount Generally, interest rate swaps involve the exchange of a fixed interest rate for a floating interest rate

15. SWAPS and FUTURES for Managing Risk Futures A forward contract with the feature that gains and losses are realized each day rather than only on the settlement date standardized terms (in specific lot size) central market (future exchanges) more liquidity less default risk (margin requirements) settlement price (daily marking to market) If a person expects the price of underlying asset will rise, then s/he will hold long position If a person expects the price of underlying asset will decrease, then s/he will hold short position

16. SWAPS and FUTURES for Managing Risk Future contract requires both counterparties to post collateral as initial margin Margin accounts are held by exchange’s clearing house Margin accounts are adjusted on daily basis to guarantee both parties’ eventual participation Each counterparty may exit from the contract before maturity date

17. Meaning of International Business International business refers to commercial activities that involve the exchange of goods, services, technology, or capital across national borders It encompasses a wide range of business activities conducted by companies and organizations operating in more than one country International business involves both the private and public sectors and can take various forms, including trade in goods and services, foreign direct investment (FDI), international franchising, licensing, and strategic alliances.

18. Reasons for Companies Going Global Companies go global for various reasons, each driven by strategic objectives aimed at achieving growth, competitiveness, and sustainability Market Expansion Access to New Customers: Going global allows companies to tap into new and larger markets, reaching customers beyond their domestic boundaries Increased Revenue Streams: Diversifying into international markets provides additional revenue streams, reducing dependence on a single market

19. Reasons for Companies Going Global Economies of Scale Production Efficiency: Operating on a global scale enables companies to achieve economies of scale, reducing per-unit production costs Cost Savings: Access to lower-cost inputs, labor, and resources in different regions contributes to cost efficiencies Competitive Advantage Global Presence: Establishing a global presence enhances a company's competitiveness and strengthens its brand recognition Technological Leadership: Access to global talent and resources facilitates innovation and technological advancements, providing a competitive edge

20. Reasons for Companies Going Global Risk Diversification Spread of Risks: Operating in multiple markets helps companies diversify risks associated with economic downturns, political instability, and other market-specific challenges Currency Risk Mitigation: A global footprint allows companies to manage currency risks by operating in different currencies Strategic Alliances and Partnerships Collaborative Opportunities: Going global creates opportunities for strategic alliances and partnerships with local businesses, governments, and organizations Knowledge Transfer: Collaboration with global entities facilitates knowledge transfer and the exchange of best practices

21. Reasons for Companies Going Global Regulatory and Trade Considerations Tariff Reductions: Expanding globally may lead to reduced tariffs and trade barriers, making products more competitive Compliance with Standards: Companies may expand internationally to comply with international standards and regulations Talent Acquisition and Innovation Access to Talent: Operating globally provides access to a diverse pool of talent, fostering innovation and creativity Cultural Diversity: A global workforce brings cultural diversity, enhancing problem-solving and decision-making capabilities

22. Reasons for Companies Going Global Strategic Positioning First-Mover Advantage: Being among the first to enter a new market can provide a significant advantage, establishing a brand presence and capturing market share Strategic Alignment: Global expansion allows companies to align their operations with global industry trends and standards Government Incentives Incentives and Subsidies: Some governments offer incentives, subsidies, or tax breaks to companies that expand globally, encouraging international business activities

23. Reasons for Companies Going Global Diversification of Product Portfolios Product and Service Expansion: Global expansion provides an opportunity to introduce new products or services to different markets, catering to diverse consumer needs Strategic Response to Market Trends Adaptation to Trends: Expanding globally allows companies to adapt to changing consumer trends, preferences, and emerging market opportunities

24. Domestic Vs. Multinational Financial Management Domestic financial management and multinational financial management differ primarily in their scope and the complexities associated with operating in multiple countries Scope Domestic Financial Management Primarily focuses on financial decision-making within the borders of a single country Deals with local currencies, regulations, and market conditions Multinational Financial Management Involves financial decision-making for businesses that operate in multiple countries Addresses challenges related to different currencies, diverse regulatory environments, and varying market conditions across borders

25. Domestic Vs. Multinational Financial Management Currency Considerations Domestic Financial Management Transactions are conducted in the local currency Exposure to currency risk is limited to fluctuations in the domestic currency Multinational Financial Management Involves transactions in multiple currencies Companies need to manage currency risk due to exchange rate fluctuations, impacting revenues, costs, and profits Regulatory Environment Domestic Financial Management Subject to the regulations and laws of a single country Compliance is typically with local regulatory authorities

26. Domestic Vs. Multinational Financial Management Multinational Financial Management Involves compliance with the regulations of multiple countries Must navigate diverse legal frameworks, tax laws, and regulatory requirements in different jurisdictions Risk Management Domestic Financial Management Risks are primarily associated with local economic conditions and market factors Limited exposure to geopolitical risks and currency fluctuations Multinational Financial Management Involves managing a broader array of risks, including currency risk, political risk, economic risk, and cultural differences Companies need to develop sophisticated risk management strategies to navigate the complexities of operating internationally

27. Domestic Vs. Multinational Financial Management Financing and Capital Structure Domestic Financial Management Capital is typically raised in the local market Financing decisions are influenced by domestic interest rates and market conditions Multinational Financial Management Capital can be raised in various countries and currencies. Financing decisions require consideration of global capital markets, currency exposure, and international interest rate differentials Taxation Domestic Financial Management Tax considerations are limited to the local tax rule Companies comply with domestic tax laws

28. Domestic Vs. Multinational Financial Management Multinational Financial Management Involves navigating complex international tax regulations Companies need to optimize their tax structure considering tax implications in multiple jurisdictions Financial Reporting Domestic Financial Management Adheres to local accounting standards for financial reporting Reporting practices comply with domestic regulatory requirements Multinational Financial Management May involve the use of international financial reporting standards (IFRS) or Generally Accepted Accounting Principles (GAAP) Companies need to reconcile financial reporting across different jurisdictions

29. Domestic Vs. Multinational Financial Management Decision-Making Complexity Domestic Financial Management Decision-making is relatively straightforward within the confines of a single country Fewer variables to consider in financial planning and strategy Multinational Financial Management Decision-making is more complex due to the involvement of diverse markets, currencies, and regulatory environments Requires a more strategic and integrated approach to financial management

30. Exchange Rate Quotations An exchange rate is simply the price of one country’s currency expressed in terms of another country’s currency In practice, almost all trading of currencies takes place in terms of the U.S. dollar Exchange rate quotations represent the value of one currency in terms of another currency These quotations are used in the foreign exchange (forex) market and are essential for international trade, investment, and financial transactions

31. Exchange Rate Quotations by NRB

32. Exchange Rate Quotations Methods Direct Exchange Rate Quotation In a direct quotation, the domestic currency is expressed in terms of a certain amount (or 1 unit) of foreign currency The quote is direct when the price of one unit of foreign currency is expressed in terms of the domestic currency Example If the exchange rate between the Nepalese Rupee (NPR) and the U.S. Dollar (USD) is given as 133.13 in Nepal, it means that 1 USD can be exchanged for Rs.133.13

33. Exchange Rate Quotations Methods Indirect Exchange Rate Quotation In an indirect quotation, the foreign currency is expressed in terms of a certain amount of domestic currency The quote is indirect when the price of one unit of domestic currency is expressed in terms of the foreign currency Example If the exchange rate between the Nepalese Rupee (NPR) and the U.S. Dollar (USD) is given as $0.007511 in Nepal, it means that Rs.1 can be exchanged for Rs.0.007511

34. Cross Rate A cross rate refers to the exchange rate between two currencies, neither of which is the official currency of the country in which the quote is provided In other words, it is the exchange rate between two currencies that do not involve the U.S. dollar (USD) as one of the currencies in the pair An exchange rate between two currencies computed by reference to a third currency, usually the US dollar

35. Cross Rate The process involves using two separate exchange rates to find the implied rate between the two non-base or non-quote currencies Example Suppose 1 USD is equal to JPY 110 and 1 USD is equal to Rs.12. Compute the exchange rate between JPY and Rs. In this case, exchange rate between JPY and Rs is calculated upon the base of USD. Cross rate = JPY/USD Rs./USD = JPY 110 Rs. 120 = 0.9167

36. Spot Rate and Forward Rate The spot rate and the forward rate are both exchange rates, but they refer to different points in time and serve different purposes in the foreign exchange market Spot Rate The spot rate is the current exchange rate at which a currency pair can be bought or sold for immediate delivery In other words, it's the rate at which a foreign exchange transaction is settled "on the spot" or immediately The spot rate is influenced by the current market conditions and supply and demand forces

37. Spot Rate and Forward Rate Forward Rate The forward rate, on the other hand, is the exchange rate at which a currency pair can be bought or sold for delivery and settlement at a specified future date Forward rates are determined by the spot rate and the interest rate differentials between the two currencies involved The forward market allows participants to hedge against future exchange rate movements or to speculate on future currency movements The exchange rate that will be used is agreed upon today and is called the forward exchange rate

38. Spot Rate and Forward Rate For example, the spot exchange rate for the Swiss franc is, SF 1 = $1.1373 The 180-day (6-month) forward exchange rate is, SF 1 = $1.1391 This means you can buy a Swiss franc today for $1.1373, or you can agree to take delivery of a Swiss franc in 180 days and pay $1.1391 at that time Notice that the Swiss franc is more expensive in the forward market ($1.1391 versus $1.1373) Because the Swiss franc is more expensive in the future than it is today, it is said to be selling at a premium relative to the dollar For the same reason, the dollar is said to be selling at a discount relative to the Swiss franc.

39. Purchasing Power Parity (PPP) The idea that the exchange rate adjusts to keep purchasing power constant among currencies Purchasing Power Parity (PPP) is an economic theory and exchange rate determination concept that suggests that, over time, exchange rates between two currencies will equalize the prices of a basket of goods and services in those two countries An increase in inflation decreases the value of currency Purchasing Power Parity theory attempts to quantify this inflation – exchange rate relationship

40. Purchasing Power Parity (PPP) There are two forms (types) of PPP Absolute PPP Relative PPP The absolute form of PPP suggests that the prices of the same products in different countries should be equal when measured in a common currently The basic idea behind absolute purchasing power parity is that a commodity costs the same regardless of what currency is used to purchase it or where it is selling

41. Purchasing Power Parity (PPP) Example If a beer costs £2 in London, and the exchange rate is £0.60 per dollar, then a beer costs £2/0.60 = $3.33 in New York In other words, absolute PPP says that $1 will buy you the same number of, say, cheeseburgers anywhere in the world Let, S be the spot exchange rate between British Pound and the US Dollar today and P UK and P US be the price of goods in UK and US respectively Then, the price of a beer in US is P UK = S × P US If PPP does not hold, then an arbitrage opportunity would be possible

42. Purchasing Power Parity (PPP) For absolute PPP to hold absolutely, several things must be true: The transactions costs of trading goods—shipping, insurance, spoilage, and so on— must be zero There must be no barriers to trading apples—no tariffs, taxes, or other political barriers Finally, goods in New York must be identical to the goods in London. It won’t do for you to send red apples to London if the English eat only green apples

43. Purchasing Power Parity (PPP) The relative form of PPP takes into account the changes in price levels over time It suggests that the rate of change in the exchange rate should be equal to the difference in the inflation rates between two countries Relative purchasing power parity does not tell us what determines the absolute level of the exchange rate Instead, it tells what determines the change in the exchange rate over time

44. Purchasing Power Parity (PPP) In general, relative PPP says that the change in the exchange rate is determined by the difference in the inflation rates of the two countries Example Suppose the British pound–U.S. dollar exchange rate is currently S = £0.50. Further suppose that the inflation rate in Britain is predicted to be 10 percent over the coming year, and (for the moment) the inflation rate in the United States is predicted to be zero. What do you think the exchange rate will be in a year?

45. Purchasing Power Parity (PPP) If we think about it, we see that a dollar currently costs 0.50 pounds in Britain With 10 percent inflation, we expect prices in Britain to generally rise by 10 percent So we expect that the price of a dollar will go up by 10 percent, and the exchange rate should rise to £0.50 × 1.1 = £0.55 If the inflation rate in the US is not zero, then we need to worry about the relative inflation rates in the two countries For example, suppose the U.S. inflation rate is predicted to be 4 percent Relative to prices in the United States, prices in Britain are rising at a rate of 10% - 4% = 6% per year So we expect the price of the dollar to rise by 6 percent, and the predicted exchange rate is £0.50 × 1.06 = £0.53

46. Purchasing Power Parity (PPP) Relative PPP says that the expected exchange rate at some time in the future, E(S t ), is: E(S t ) = S × [1 + ( h FC – h DC ) t

47. Purchasing Power Parity (PPP) Suppose the Japanese exchange rate is currently 105 yen per dollar. The inflation rate in Japan over the next three years will run, say, 2 percent per year, whereas the U.S. inflation rate will be 6 percent. Based on relative PPP, what will the exchange rate be in three years? Because the U.S. inflation rate is higher, we expect that a dollar will become less valuable. The exchange rate change will be 2% - 6% = - 4% per year.

48. Purchasing Power Parity (PPP) Over three years, the exchange rate will fall to: = E(S 3 ) = S × [1 + ( h FC - h US )] 3 = 105 × [1 + (- 0.04)] 3 = 92.90 Thus, expected exchange rate is 92.90 per USD