Companies doing business abroad face economic exposure, including fluctuating exchange rates, unstable governments, and the possibility of foreign countries not honoring debts. Hedging with options can offset losses and control equity. Long-term investments are necessary for companies seeking revenue abroad.
As the number of companies participating in international markets grows, so does the threat of economic exposure. Economic exposure is the risk of doing business abroad. Some of the most common risks include fluctuating exchange rates, unstable governments and unstable economies. The possibility of foreign countries not honoring their debts is another factor. Another consideration is the increased expense of protecting the health and safety of employees. These factors affect a company’s cash flow and earnings, but the long-term gain potential of doing business abroad makes the risks acceptable for many companies.
An example of economic exposure is if a company enters into a trade agreement with a small foreign nation and that nation becomes involved in a civil war. There is then a high probability that the country will not honor its debt obligation to the deal. Depending on which side wins, the permanent government could renege on the previous agreement. On the other hand, even if the country does not change leadership hands, it may be burdened with the expenses of restoring the country, and therefore money to pay off debts may not be available.
Companies that take the risk of economic exposure hedge the risk with stock, currency, or commodity options. An option means that the company has the right to buy or sell its own options or use them as leverage or hedging. Like leverage, the option allows the company to control its equity in the overseas business. When used for hedging, the option protects the company from market fluctuations. It also offsets losses from economic exposure. The option value is negotiated at the beginning of business with the foreign company or government.
When a company buys an option, it usually does so for an amount equivalent to the original investment, and the option has a fixed duration. If the company chooses not to exercise its option within the negotiated period, the option will expire. An option is a correct and non-automatic position that a company must assume.
Most companies that choose to do business abroad don’t exist in the short term. These are long-term investments that the company anticipates will generate decent revenue in the future. A company looking for a quick return on investment may be better invested in its home country. The risk inherent in economic exposure can be too great for a quick recovery.
Asset Smart.
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