In this article we will discuss about the types of international transactions and the risks associated with it.
Types of International Transactions:
Cross-border flows primarily occur due to international trade, FDI and cross-border portfolio investment. They also occur due to unilateral movement of funds between residents in two different countries (gifts are an example), payment to residents for services rendered(salary earned), authorized use of intangible assets by entities in another country (royalties, sale of patent rights), tourism, education and medical treatment.
International trade refers to the import and export of goods between countries. Trade in goods and services forms part of the current account of the Balance of Payments of a country. International trade transactions may be invoiced in the currency of the exporting country, the importing country, or in an internationally accepted currency (such as the US dollar).
Countries strive for a Balance of Trade surplus (the difference between exports and imports during a period) rather than a deficit. Since a Balance of Trade deficit leads to a decline in foreign exchange holdings, many countries (including India) enunciate export promotion policies in a bid to improve exports. But competitive repositioning of exchange rates generates temporary benefits, and at worst, triggers a currency war.
Foreign direct investment created multinational corporations, many with sales revenues that rival the GDP of small nations. The relative importance of MNCs in the world economy has increased over time. FDI is an emotive issue in many countries since it evokes nationalistic concerns, and a fear of the loss of control on the nature and volume of economic activity in a country.
Beginning in the 1980s, many emerging markets (including India) went in for stock market liberalization. Institutional investors from developed countries, particularly hedge funds, pension funds, mutual funds, dedicated emerging market funds, and insurance companies were at the vanguard of channelling portfolio investment to South-east Asia, Latin America and Mexico. FII flows are inherently more volatile than FDI, since they are prone to swift reversals.
Cross-border investment offers opportunities for portfolio diversification, and increased risk sharing between foreign and domestic investors. FII activities impart liquidity to the capital market in the host country. The higher liquidity reduces the equity risk premium, lowering the cost of equity, and the overall cost of raising capital.
Risks in International Transactions:
There are numerous risks in transactions involving foreign currencies. Risk management requires that these risks be identified, quantified, and monitored. Some risks (such as exchange rate risk) affect all cross-border currency movements, while others are limited to investment decisions or financing decisions. Risk management includes risk sharing, risk transfer, and risk mitigation by contractual and non-contractual methods.But risk management is fundamental to International Finance, since all parties to contracts that involve cross-border movements of currency desire risk management solutions.
Hedging requires the ability to accurately estimate risk, and choose the best possible response. For example, while all derivative products enable a business firm to hedge risk, the firm must make an ex ante decision regarding which product (namely, forward, future, or option contract) will best minimize this risk. Choice of the product is dictated by its cost, flexibility, and ability to match the maturity profile of the risk.
Selection of a risk management method is also subject to availability. Many countries do not have currency derivatives exchange and firms in these countries may have to make do with a smaller opportunity set of responses. Risk management is central to value maximizing behaviour, and the objective of the firm is assumed to be wealth maximization.