Chapter 11 - Financial risk

Question 1

What is financial risk?

Answer 1

Financial risk is a risk of a change in financial condition such as an exchange rate, interest rate, credit rating of a customer or price of a good.

Question 2

What are the types of financial risk?

Answer 2

• Credit risk
• Political Risk
• Interest rate risk
• Currency risk

Question 3

What is credit risk?

Answer 3

Credit risk is a risk of non-payment or late payment of receivables. Credit risk will always exist in businesses that make credit sales and therefore it needs to be managed.

Question 4

What are the most common methods used to manage and control credit risk?

Answer 4

• Strong credit control procedures, including:
  a) policies regarding credit checks
  b) credit limits and terms
  c) debt collection activities such as aged debtor analysis, statements and reminders
• Insuring against the risk - it is possible to take out credit risk guarantees to act as insurance against debtor default
• Debt factoring without recourse - the debts can be sold to a factoring business but without the obligation to buy back those debts in the event of default

Question 5

What kind of controls may the government impose to control their political stability?

Answer 5

• Exchange control regulations, which will ration the supply of foreign currencies which restricts residents from buying goods abroad; or banning the payment of dividends to foreign shareholders such as holding companies in multinationals, who will then have the problem of blocked funds.
• Import quotas
• Import tariffs
• Insist on a minimum shareholding, i.e. that some equity in the company is offered to resident investors
• Company structure may be dictated by the host government - requiring, for example, all investments to be in the form of joint ventures with host country companies

Question 6

How to manage political risk?

Answer 6

Companies cannot prevent political risk, but they should seek to minimise it whenever the risk appears significant. Before undertaking a FDI, a company needs to assess its exposure to political risk by:

• Using political ranking tables such as Euromoney magazine tables;
• Evaluating the country’s macro-economic simulation - balance of payments, unemployment levels, per capita income, inflation, exchange rate policy, rate of economic growth;
• Evaluating the current government’s popularity, stability and attitude to foreign investment, together with the attitude of opposition parties;
• Looking at the historical stability of the political system;
• Looking at changing religious and cultural attitudes;
• Taking advice from the company’s bank, and etc.

Question 7

How to manage economic risk?

Answer 7

• Diversification of production and sales (e.g. foreign production and/or sales)
• Diversification of suppliers
• Diversification of financing
• Marketing