Problems of internationalisationrisk as a part of economic risk and, given the definition of economic risk that we have
just met, this is correct. Generally, however, transaction risk tends to be seen as being
related to short-term receivables (debtors) and payables (creditors), whereas economic
risk tends to be related to more long-term hazards of exchange rate movements.
Economic risk covers such areas as:
l long-term borrowings in foreign currencies becoming costlier than expected to
service (interest payments) and repay the principal of the borrowings, as a result of
a shift in exchange rates;
l projects not having as high an NPV in practice as was planned, because the home
currency has strengthened against the relevant foreign ones, so that the value of
operating cash flows is less than planned; and
l the business, when it is supplying from the home country, finding it hard to com-
pete in the foreign market as a result of the home currency strengthening against
the relevant foreign one.
Businesses affected by economic risk
We might think that it is only businesses that transact part of their activities in a for-
eign currency that are exposed to foreign exchange economic risk, but this is not neces-
sarily the case. Most businesses are affected by economic risk. Take an imaginary
business, Little England plc, that uses UK supplies and sells its product or service in
the UK market. At first sight, such a business is immune from economic risk. What if
it has a market competitor who supplies the product or service from Japan, and ster-
ling strengthened against the yen? Now the Japanese product could become cheaper,
in sterling terms, without the Japanese business receiving less for it in terms of yen.
This could quite easily severely damage Little England’s ability to sell, at least at prices
that it was used to charging. To take another example, what if a major element of Little
England’s market is other UK businesses that are principally engaged in the export
market, and sterling strengthens against most other currencies? Little England’s main
customers may well find that their markets are under pressure as a result of strong
sterling. This might well lead to a fall in sales volumes and/or revenues for Little
England, despite the fact that it does not sell overseas itself.
Managing economic risk
Managing economic risk is not as easy as managing transaction risk, which, to a great
extent, is pretty straightforward. There are well-established techniques for managing
transaction risk, such as options and forward contracts, which can solve the problem,
though not without cost. While there are some similar techniques available for man-
aging economic risk, much of economic risk management is concerned with strategic
approaches that try to limit exposure. Such approaches include:
l avoiding being too exposed to one single foreign currency;
l trying to trade in foreign countries where there is known to be some intent on the
home government’s part to hold the home currency at a broadly constant exchange
rate, relative to relevant foreign ones; and
l taking steps to try to balance payments and receipts in the same currency.
As with transaction risk, there are arguments for doing nothing about economic
risk. One aspect of this, self-insurance, was discussed in the context of transaction risk
earlier in this section. Another point is that taking the kinds of steps listed above might