ECONOMIC

RISK
MANAGEMENT
118.Gourav Kumar Ganguly
139.Gaur Hari Pal
151. Siddhant Sethia

Group 7|

PGDM-B | SIMSR

ROADMAP FOR ECONOMIC

RISK
1.Economic risk
2.Principal economic risks in international markets
3. Exchange Risk Management
a) Exchange rate risks
b) Exchange risk management
c) How foreign investors can protect themselves
from these exchange rate risks
d) Standard methods of hedging an exposed
dollar liability
4. Economic Freedom Index
5. Uncontrollable Risks

ECONOMIC RISK

Economic risk:
An economic risk can be defined as the likelihood that economic
mismanagement will cause drastic changes in a country's business
environment that hurt the profit and other goals of a particular business
enterprise.
Countries often impose restrictions on business activities on the grounds of
national security,
conserving natural resources,
scarcity of foreign exchange,
to curb unfair trade practices,
to provide protection to domestic industries.
Hence it is essential to know whether potential risks outweighs the benefits.

Principal economic risks in international markets

are:

Exchange controls
Local content requirements
Import restrictions
Restrictions on fund flow
Run away inflation
High Debt
Balance of payment
Trade deficit

Exchange controls:
Scarcity of foreign exchange exchange control measure in a country.
Adverse affects:
repatriation of profits and
repatriation of sales proceeds to the home country

Local content requirements:

Local content requirements for extending export incentives or
putting a country-of-origin label.
Examples:
EEC termed assemblers as screw driver operations and
imposed a local content requirement of 45 percent.
NAFTA imposes 62.5% as local content requirements for cars
manufactured in member countries.
Import restrictions:
To protect domestic industry, governments often impose selective ban on
import.
Such restrictions vary from total ban on imports to quota restrictions.
This leads to higher product costs and comprise on the product quality.

Exchange rate risks

Many countries have been experiencing
ongoing fiscal deficits,
rapid money-supply growth,
high inflation rates.
So devaluation crises appear from time to time.
Recent devaluation episodes includes:
Mexican crisis of 1994,
Asian crisis of 1997,
Russian crisis of 1998
These events have shown what heightened foreign exchange volatility can
cause.
Capital flows have become more sensitive countrys financial system and economic conditions than they have been in
the past

How foreign investors can protect themselves

from these exchange rate risks ?
Here are some ways managers can cope with these country risks:
1.Host country currency Devaluation assessment:
The theory of Purchasing Power Parity provides a guide to likely exchange rate
changes.
Compare a countrys cumulative inflation over a number of years with the cumulative
inflation rate of its major trade partners.
If the difference in cumulative inflation rates exceeds the percentage change in the
foreign exchange rate, then devaluation is a real possibility.

2.Purchase price spread over a long time period:

This allows domestic currency to be purchased at a lower cost if devaluation occurs.

3.Negotiate a lower price with the supplier:

The extent to which this can be done will depend upon the relative bargaining power
of the buyer and the seller and the profit margin of the seller.
Price revision based on a band e.g. 10% for exchange rate and raw material rate.
4.Absorption of the price increase:
The extent possible by the buyer and pass on the rest to the consumer.
The extent to which this can be done will depend on the profit margin the buyer
enjoys and the competitive and the demand conditions prevailing in his market.
5.A third and complementary, approach is to take steps to minimize exchange
risk.
The four most common ways of doing this are
A. exchange risk avoidance,
B. changing sourcing,
C. exchange risk adaptation and
D. currency diversification. Of these four approaches , exchange risk adaption is most
commonly used.

5 A. Risk avoidance
Exchange risk avoidance strategy avoids foreign currency transactions.
applicable - firm which makes all its purchases and sales with local buyers only.
Expose the business to the possibility of interest rate increases as a result of a
central banks response to foreign exchange rate devaluation.
For foreign-owned financial institution:
Possibility of a run on deposits if the depositors seek to withdraw funds in order
to
transfer them aboard.
impractical strategy as most industries:
use imported materials,
export some of their output,
compete with imported products
5 B. Changing/ Diversifying sourcing:
Another strategy is to change the source of purchasing.
For e.g. If the US goods becomes costlier due to dollar appreciation, then change
the source from US to some other countries where the product is cheaper either
due to depreciation of their currencies or other reasons.
A no. of companies have diversified the countries of sourcing to spread and

5 C. Currency Diversification
Currency diversification is a strategy dont put all of your eggs in one basket
firm to hold assets and liabilities in several currencies to reduce the impact of
unexpected exchange rate changes.
5 D. Risk adaptation
Exchange risk adaptation strategy includes calls for protecting all liabilities denominated in foreign currency with equal-value, equalmaturity assets denominated in that foreign currency
Example:
Assume an Indian firm has contracted to buy $100,000 of machinery from a foreign
supplier for use in its manufacturing operations.
The purchase is payable in six months in US dollars.
Firm may obtain some equal-value dollar asset maturing in 180 days.
depositing funds in a dollar-denominated bank account for six months
arranging a swap of the dollar liability for some other firms India rupee liability.

Standard methods of hedging an exposed dollar liability

include:
1. Obtaining a dollar-denominated financial asset (e.g., a time deposit or a CD) that
matures when the liability comes due.
2. Hedging foreign exchange risks with a forward contract.
3. Finding a buyer for your firms products and agreeing to receive payment in US
dollars
for the same value and time as the liability.
4. Agreeing with a American firm to exchange your dollar liability for their Indian
operations rupee liability.

ECONOMIC
FREEDOM INDEX

ECONOMIC FREEDOM INDEX

- RANKINGS

INDIAS EFI

PARAMETERS CONSIDERED

IMPLICATIONS FOR
COMPANIES
Countries with higher EFI scores have had higher rates of Long term

economic growth and highest living standards

Government control and ownership of FOP decreases the risk affinity of

Entrepreneurs and Companies and vice-versa

Innovation stimulation in high EFI countries

Less risk of Nationalisation, Adverse Taxation

UNCONTROLLABL
E / HAND OF
GOD RISKS

LIST OF UNCONTROLLABLE
RISKS
Natural disasters
Terrorism

NATURAL DISASTERS
MITIGATING RISK
Natural disasters often lead to lower economic growth and a worsening in

fiscal and external balances. They can also have a significant impact on
poverty and social welfare.

WAYS TO STRENGTHEN
DISASTER RISK MITIGATION
AND RESPONSE

Identify risks and integrate them explicitly into macro frameworks to help determine

how much to self insure and how much to spend on mitigating impact;

Ensure sufficient fiscal space, and flexibility within fiscal frameworks, to help redeploy

spending rapidly;

Improve transparency to bring about effective use of disaster assistance and limit

contingent liabilities to the state;

Strengthen coordination ex post among multilateral institutions, donors, the

authorities and civil society organizations, particularly where administrative capacity

is limited;

Use reconstruction as an opportunity to accelerate broader growth-enhancing

structural reforms; and

Looking further ahead, explore ideas about how to promote insurance coverage, since

insurance penetration reduces the real costs of disasters without raising fiscal burdens

TERRORISM THE WILD

CARD
Protecting employees and

corporate assets is the

responsibility of operating
managers throughout any
corporation. In most
organizations, few people are
fully cognizant of exposures
such as kidnapping and
extortion. But terrorism, crime,
and political instability risks are
facts of life, and corporate
leaders must deal with them in
transacting business in our
increasingly global economy

CURRENT RISKS OF
PARTICULAR CONCERN TO
MULTINATIONALS

Leftist guerrillas who kidnap foreign corporate employees in rural Colombia and in

neighbouring Ecuador and Venezuela.

Criminal gangs that target executives in Mexico, Guatemala, El Salvador, Honduras,

Haiti, Brazil, and elsewhere in Latin America.

Tribal gangs that attack multinationals and kidnap their personnel in Nigerias oil-

rich Niger Delta.

Aggressive, organized-crime groups that run protection rackets in Russia, other

parts of the former Soviet Union, and eastern Europe.

Vendors, distributors, and joint-venture partners who threaten and even employ

violence to resolve business disputes in Russia, China, and other countries with
primitive judicial systems.

Islamic zealots who target foreigners and foreign business interests as part of their

jihad.

COMPANYS RESPONSE
Well-managed corporations respond by:
(1) carefully analysing risks and weighing them against potential rewards

of a particular project;

(2) fully informing employees of the hazards they face;

(3) supplying the wherewithal to enhance their safety through training,

technical means such as armoured cars and, in some cases, protective

details; and

(4) planning the companys response in the event of a kidnapping or an

extortion.

A CRISIS MANAGEMENT
TEAM
Companys core crisis management team should consist of at least three

individuals:

The ultimate decision makerthe CEO or his or her designee;

The coordinator, often the corporate security director, risk manager, or

chief of international operations; and

The general counsel.

The team also might include:
A finance officer (to arrange for the ransom);
A human resources specialist (to oversee the care of a hostages family);

and

A public relations specialist (to handle press inquiries).