Competition at Local and International Levels - Case Study Example

financial case study Introduction Competition at local as well as international level has become significant and firms are actively looking for new investment opportunities in order to successfully develop their core competencies as well as maintain their competitive advantage. However, investing into foreign countries is one of the significant investments that any firm make because it is always done within an aim of achieving the strategic objectives of the firm. Firms often invest in new markets in order to expand their existing markets and allow them to generate more revenue and profitability by gaining access to new markets. However, this decision may not be free from the relative risks that investing into new markets and countries can carry. Various competitive forces may be at play and the firm has to strategically devise its strategies to effectively negotiate with the different risks that may arise after investment is made. Joblot Plc’s decision to enter into Lazka may be one of the significant investment decisions that the firm has to make. However, this decision will involve a comprehensive analysis of the various important factors that will contribute towards assessing the impact of various risks. The possible sources of risks may include political risk, foreign exchange risk, market risk as well as other risks that may generally arise in due course. This report will provide a comprehensive overview of the generalized risks that Joblot Plc may face while investing into Lazka using the currency of Lazka. Further, this report will also present a set of recommendations to the Board in order to reduce these risks. General Risks Any investment that is made always carries different risks and investors have to compensate themselves in order to undertake such investment decisions. The risks therefore are often covered through charging premium over an above certain rate offered by relatively risk free investment opportunities. Such type of risks can arise due to various reasons including risks arising out of changes in the interest rates, risks arising out of changes in the rate of return offered by alternative securities, political risk etc. However, when a decision is made to make international investments, the overall scenario changes because investing internationally adds more risks to the investments and the extent of existing risks becomes more significant. It is also critical to note that when a firm intend to trade and invest into currency other than its home currency, there can arisen other different types of risks which are associated with that particular currency.(Nancy,2004). Joblot Plc’s decision to trade and invest into Lazka’s currency and subsequently remittance of the profits from Lazka to itself therefore carries certain particular risks which are discussed below: Transaction Exposure Transaction exposure is probably the most important type of risks a firm may incur when dealing in foreign currency. Transaction exposure arises when there is a possibility that the future cash flows of a firm are affected by the changes in the foreign currency exchange rate. Thus Joblot Plc’s decision to invest and trade into the Lazka’s currency will pose this type of risk because it is expected that the future government of the country will allow the currency rate to be determined under the free market forces. It is also critical to understand that the transaction exposure can result into other risks also such as systematic and legal risks. Systematic risks can arise when the financial system of a country fails to honor its obligations. In case of Joblot, Plc this may arise when its remittances are either blocked by the actions of Lazka’s central bank or there are other restrictions on the movement of foreign exchange from the country. Similarly, legal risk can also be created when there is unsystematic understanding or application of the law regarding the settlement of foreign exchange transactions. This type of risk however, can be minimal when the currency is pegged or fixed against any major currency i.e. Sterling in this case. As such fixed rate of exchange between the home currency and the currency of trade may minimize the overall transaction exposure and firm may not have to incorporate premium against such exposure till the exchange rate is fixed against the home currency. However, as soon as the exchange rate is determined under the free floating basis, this exposure can be significant and firm’s cash flows may be affected in adverse manner if home currency depreciates or appreciates against the other currency. Economic Exposure Economic exposure is another type of risk which a firm can face while dealing with a foreign currency. Economic exposure basically measures the impact of changes in the exchange rate on the firm’s cash flows as well as the profitability. Adverse changes in the exchange rate may reduce the cash flow of the firm as well as may create losses due to changes in the exchange rate. A favorable change in the foreign exchange rate however, can result into gains from taking the currency exposure too.(Zask,2000). A higher volatility in currency against international currency therefore can create significantly more risks as compared to the currency which is relatively more stable. Since Lazak’s inflation is higher as compared to its neighboring countries therefore higher inflation rate may force its currency to depreciate against sterling. The currency depreciation therefore will finally affect the profitability of the Joblot Plc because it will be getting fewer Starlings as Lazak’s currency depreciates further. Translation Exposure Translation exposure finally emerges when firm prepares its financial statements and the changes in the foreign exchange rate finally affect its financial statements. Adverse changes in the foreign exchange rate of Lazak will adversely affect its balance sheet as its investments into Lazak will now be accounted for at lesser rate. Similarly, changes in the foreign exchange rate can affect the profit and loss figure of the firm as adverse changes definitely result into the loss on foreign exchange exposure of the firm. In a sense translation exposure effectively captures both the above types of exposures and reflects the affects on the firm’s balance sheet as well as profit and loss. Strategies to manage the risks Hedging is one of the most effective tools that can be used to safeguard oneself against the above risks. All the international firms engage into hedging activities and design their strategies in a manner that minimize the exposure to risk. Hedging takes place when a firm attempts to secure its existing exposure by taking reciprocal positions in a manner that losses from one position can be compensated from the gains achieved from other position. Some of the strategies that Joblot Plc can execute are: Forward contracts Joblot Plc can enter into the transaction with a financial institution to buy or sell the currency of Lazak at a pre-determined rate at a future date. Purchasing foreign currency at a pre-determined rate at a future date is called forward contract and it basically safeguard the firms from adverse changes in the values of the currency. It is important to note that when a firm enters into a forward contract it has an obligation to buy or sell that much amount of currency at the agreed date and rate. The differences in the rate at which currency was booked in a forward contract and the actual spot rate therefore needs to be settled by either party according to the nature of the transaction.(Kolb & Overdahl,2003). Thus by entering into a forward contract a firm can basically hedge itself against the adverse changes in the currency rates. It is however, important to note that the firm may incurs losses, if it has bought foreign currency, also if actual rate, at the date of settlement, exceeds the forward rate. Future contracts Future contracts are similar to the foreword contracts wherein both the parties agree to sell or buy a particular currency at a fixed rate and at a given time period. The basic difference between the forward and future however, is the fact that a future can be traded on stock exchange whereas forwards are not usually traded on the stock exchange. All other mechanisms often remain the same except this fact and as such firm can either incur losses or profits besides hedging themselves against the risks. It is also important to note that future contracts are binding on each party and have to be settled on future given date by both the parties.(Baz & Chacko,2004). Options Another important strategy which Joblot Plc can exercise is to purchase or sell the option contracts to secure itself against any potential adverse changes in the foreign exchange. Option contracts are also similar to that of future contracts however; there are two basic and fundamental differences between the two. If Joblot Plc decides to buy or sell options to hedge its foreign currency exposure in Lazka’s currency than it has to pay or receive a certain amount of premium. It is however, important to note that option contracts will not be binding on the firm and on the settlement date, Joblot Plc will have the option to exercise or not to exercise the option contracts and all it losses is the premium paid. Conclusion The above discussion indicates that there are different methods through which foreign exchange exposure and risk can be minimized. References 1. Baz, J, Chacko, G (2004). Financial derivatives: pricing, applications, and mathematics. Illustrated. ed. Cambridge: Cambridge University Press. 2. Kolb, R (2003). Financial derivatives. 3rd. ed. New York: John Wiley and Sons. 3. Nancy, B (2004). Optimal Hedging and Foreign Exchange Risk [online]. [Accessed 14 April 2010]. Available from: http://findarticles.com/p/articles/mi_qa3857/is_200410/ai_n9521252/ 4. Zask, E (2000). Global investment risk management: protecting international portfolios against currency, interest rate, equity, and commodity risk. illustrated. ed. New York: McGraw-Hill Professional,. Read More