International trade is a vital source of income and growth for many financial institutions, but it also exposes them to various risks that can affect their profitability and reputation. In this article, we will explore some of the main types of risks that financial institutions face when conducting international trade and how they can manage them effectively.
Currency risk is the risk that changes in exchange rates will affect the value of financial assets, liabilities, or cash flows denominated in foreign currencies. Financial institutions that engage in international trade may face currency risk when they buy or sell goods and services, lend or borrow money, or invest or hedge in foreign markets. Currency risk can be reduced by using forward contracts, futures, options, swaps, or other derivatives to lock in exchange rates or hedge against fluctuations.
While currency risk can be adequately handled by hedging, this adds to costs and can quickly turn a deal with slim margins - but still worth doing - into something no longer profitable. The risk here is that during the preparation time, exchange rate volatility leads hedging costs to shift strongly and the costs incurred during preparation are written off when the deal doesn't go through. Do that enough times and you will see a negative impact to profitability.
Credit risk is the risk that a borrower or counterparty will fail to repay a loan or honor a contractual obligation. Financial institutions that engage in international trade may face credit risk when they extend credit to foreign customers, suppliers, or intermediaries, or when they participate in trade finance arrangements such as letters of credit, bills of exchange, or documentary collections. Credit risk can be mitigated by conducting due diligence, diversifying portfolios, securing collateral, obtaining guarantees, or using credit insurance or export credit agencies.
While ratings can give you an idea of credit risks, they can be misleading if you are working, for instance, with small cap companies and the ratings are for large cap companies in that country. More important is strong due diligence and understanding above all the risks for repatriation to avoid unpleasant surprises. Using local currencies introduces further uncertainties. Credit insurance mitigates these risks, but may add significantly to costs and may hence reduce profitability of these costs cannot be passed on.
Operational risk is the risk that losses will result from inadequate or failed internal processes, systems, people, or external events. Financial institutions that engage in international trade may face operational risk when they deal with complex and diverse regulatory, legal, tax, cultural, or logistical issues across different jurisdictions and markets. Operational risk can be managed by implementing robust policies, procedures, controls, audits, training, and contingency plans, as well as by outsourcing or partnering with reliable service providers.
My experience is that if a company does not have robust and documented processes, operational risk is much higher than anyone imagines, especially if volatility is involved. Processes must include alternative scenarios and exit scenarios with clear triggers that are also shared with business partners so that all are operating on the same page.
I agree with internal and external events that’s may add some operational risks specially in multinational companies with different country banks and intermediaries
Political risk is the risk that political instability, violence, or intervention will affect the business environment or the enforceability of contracts in a foreign country. Financial institutions that engage in international trade may face political risk when they operate in countries that have weak governance, corruption, civil unrest, sanctions, expropriation, nationalization, or currency controls. Political risk can be minimized by monitoring and assessing the political situation, diversifying geographically, negotiating favorable terms, or using political risk insurance or multilateral agencies.
In my experience in Sudan market, big issue is sanctions so no direct transfer from buyer account to seller account , so seller need to establish business name in other countries and this take some of profit margins and adds some operational risks
My experience is that political risk should be a key component of any go/no go decisions, and scenarios should be planned for based on events.
Market risk is the risk that changes in market prices, rates, or volatility will affect the value or performance of financial instruments or portfolios. Financial institutions that engage in international trade may face market risk when they trade or invest in foreign securities, commodities, or derivatives, or when they are exposed to interest rate, inflation, or liquidity risk. Market risk can be controlled by using hedging strategies, diversification, asset allocation, or risk management tools.
Compliance risk is the risk that non-compliance with laws, regulations, standards, or codes of conduct will result in fines, penalties, sanctions, litigation, or reputational damage. Financial institutions that engage in international trade may face compliance risk when they have to comply with multiple and changing rules and requirements related to anti-money laundering, anti-terrorism financing, sanctions, trade restrictions, data protection, consumer protection, or environmental and social responsibility. Compliance risk can be reduced by establishing a strong compliance culture, function, and system, as well as by seeking expert advice or guidance.