For businesses to operate in different countries around the world, they will require access to different financial markets, deal with foreign currencies and secure funding in the host country. In this topic, we will look at these different financial aspects to understand what is involved in global business operations. We will also consider some of the risks that global businesses will need to consider.
Welcome to Topic 4: Economic and Financial Considerations for Operating a Global Business.
In this topic, you will learn about:
- Foreign exchange markets
- Exchange risk
- How companies protect themselves against exchange risk
- Purchasing power parity (PPP).
These relate to the Subject Learning Outcomes:
- Explain the impact of globalisation on the business environment.
- Outline how global businesses are affected by the type of environment (legal, political, economic, financial and social-cultural) they operate in.
Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these prior to attending your scheduled seminar with your lecturer.
Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.
Research country risk and post your findings on the discussion forum. This task relates directly to your final assessment task. You can access the activities by clicking on the links in the topic. You can also navigate to the forum by clicking on ' Topic 4: Forum activity 1'. You can also navigate to the forum by clicking on 'BUS100 Subject Forum' in the navigation bar for this subject.
Assessment 1 – If you were allocated this week by your lecturer, you will need to co-facilitate the discussion on the discussion forum as per the assessment instructions provided. You can access the activities by clicking on ‘Topic 4: Assessment 1: Facilitation & Participation.’ You can also navigate to the forum by clicking on 'BUS100 Assessment 1 Forum' in the navigation bar for this subject.
Assessment 1 – For all students not allocated a facilitation task this week, you are expected to actively participate in the class discussion and respond to peer facilitation. You can access the activities by clicking on ‘Topic 4: Assessment 1: Facilitation & Participation.’ You can also navigate to the forum by clicking on 'BUS100 Assessment 1 Forum' in the navigation bar for this subject.
Assessment 2 – Do additional research for your case study analysis and develop your draft. Be prepared to explain what you have done in the consultation session with your lecturer.
Read through this week’s topic content.
Foreign exchange markets
The foreign exchange market (also known as the forex market, currency trading market or FX) is where a currency is bought, sold and exchanged. Rather than having a central location, this is made up of an international network of brokers and traders who facilitate the exchange. The following figure illustrates the relationship of each of the following components within the Foreign Exchange Market:
In essence, the foreign exchange market is a global network of entities that convert the currency of one country to the currency of another country, enabling international trade to happen across country borders and in their respective currencies.
The following forex basics video provides an overview of the foreign exchange market basics.
Rather than having a value in itself, currency value is provided in relation to other currencies. This is known as the exchange rate. The value of a specific currency is always presented in relation to another currency. For example, AUD$1 = £2.45 GBP shows us that one Australian dollar is worth the same as two British pounds and forty-five pence.
You might be familiar with foreign exchange from being a tourist in another country and needing to exchange your home currency to the currency of the country you were travelling to. However, the exchange of physical money is actually one of the least common transactions in terms of foreign exchange. More common forms of foreign exchange transactions include online transfers, cheques (or drafts) and contracts for future currency purchases or sales (Collinson et al. 2020).
The exchange rate is mostly a result of simple supply and demand economics, impacted by several factors such as:
- Political stability
- Interest rates
- Inflation
- Public debt
- Government intervention.
Inflation
Inflation is the rate at which prices increase within a specific period. As a broad measure, inflation is an economic indicator that shows the overall increase in prices within a particular country, providing insight into the cost of living there.
Household surveys identifying common purchases as a ‘basket of goods’, provide insight into how the cost of this basket has increased over time. This cost increase in a particular base year is the consumer price index (CPI). Changes to the CPI over a period of time shows us the change in the cost of living over time (Oner n.d.). Factors that influence inflation rates include prices set by the government, seasonal factors and supply conditions.
Public debt
Public debt is also known as sovereign debt. Watch the following video, which explains what public debt is and how we can interpret the impact of public debt for a particular country.
Exchange risk
Exchange risk (sometimes referred to as foreign exchange risk) is the threat of business loss that may happen because of currency fluctuations. Regardless of whether a business is operating internationally, all businesses must consider the impact of exchange risk.
The cost of imported goods and services varies with the exchange rate. So, even businesses operating locally will be affected by changes either directly (as the costs of goods and services they purchase vary) or indirectly (as the companies in their supply chain are affected by the price variations). In terms of the businesses’ income, this may also vary if they export any goods and services as those also vary with the exchange rate.
Exchange risk is the possibility that companies may not adjust their prices to offset the fluctuations in exchange rates (Collinson et al. 2020).
How companies protect themselves against exchange risk
We have seen that if companies can adjust their costs and prices to counteract any fluctuations in the exchange rate, they do not face the problem of exchange risk.
It is only once organisations are not able to offset these fluctuations, that they will have to look at different approaches to protect themselves against a loss of income due to exchange risk. These approaches include:
- Exchange risk avoidance
- Exchange risk adaptation
- Exchange risk transfer
- Currency diversification.
Exchange risk avoidance
Exchange risk avoidance is where organisations attempt to avoid foreign currency transactions altogether. Instead, a business may operate domestically making all its purchases from local suppliers, using local contractors and selling its goods or services to a domestic customer market (Collinson et al. 2020).
The challenge is that even if firms do not have direct transactions with foreign markets, it is likely that their suppliers and contractors will. In some ways, they will always remain dependent on the impact of foreign transactions. Think of oil prices, imported goods and services and vehicles, just to name a few examples.
Exchange risk adaptation
Exchange risk adaptation is where organisations acknowledge the risk associated with a future transaction and then attempt to adapt to the expected fluctuations by either:
- Raising their prices in expectation of an exchange rate fluctuation anticipated at the time of a future transaction.
- Matching current liabilities to future payments.
Imagine that a business buys $1 000 000 worth of tractors from a foreign company. The purchase is payable in a specific currency in eight(8) months. In that period, the local currency may decrease in value compared to the foreign currency in which the purchase needs to be paid.
In this example, an organisation may raise their prices over the next eight (8) months to try and alleviate the expected reduction in their local currency and make up for the difference in advance. However, as this is not always an option, the company may instead:
- Find a bank that will agree to buy the local currency in exchange for the million dollars of foreign currency at the current exchange rate (so the bank wears the risk on behalf of the company).
- Find a buyer for the company's products who will pay you the million in foreign currency when the liability becomes due (so they wear the risk on behalf of the company).
- Find a foreign firm that has the opposite scenario in terms of needing to pay off a liability in your local currency (foreign to them) for the specific foreign currency (local to them) that you need to pay off; and agree to exchange these liabilities (so they wear your company’s liability in their local currency, and your company takes on their liability).
- Find a bank that will provide a foreign currency-denominated asset – for example, a certificate of deposit. This is where the company agrees to leave a lump sum with the bank for a set amount of time at a premium interest rate. If this interest rate is foreign currency-denominated, this means the interest matches the currency rate fluctuation risk over that period (so the bank wears the risk on behalf of the company).
- Agree to a contract that fixes the sale at the current exchange rate (so the suppliers avoid or wear the fluctuations). This is called a forward contract.
Forward contract
Forward contracts are private agreements made between two (2) parties to avoid market fluctuations. It is a contract between a buyer and a seller to trade a particular asset at a date set in the future for a specific price (Collinson et al. 2020).
For example, if two parties set up a forward contract to sell 2000 bags of grains at $2 each, even if the market changes, this sale is agreed to at $4000 regardless of what the price of a bag of grain is the time the contract settles.
Exchange risk transfer
Exchange risk transfer is where the exchange risk is passed on to an insurer or guarantor. The central bank often offers this option. A central bank is the financial institution that oversees monetary policy, establishes national interest rates, and produces and distributes a country’s money.
Currency diversification
Currency diversification is the fourth strategy when it comes to a company protecting itself from exchange risk. The organisation spreads the risk of unexpected devaluations in a particular currency by divesting its assets and liabilities across multiple different currencies.
Currency diversification works on the idea is that fluctuations in one currency will be offset by those in another. In this way values of assets and liabilities in one country may drop while those elsewhere will rise and overall, the company has protected itself through this balancing out.
Purchase power parity (PPP)
To compare living standards and economic productivity between different countries, we can utilise a macro-economic measure called purchasing power parity (PPP). PPP assumes that the same ‘basket of goods’ should be worth the same thing in all countries. In other words, the cost of a specific range of items in a ‘basket of goods’ in one currency should cost of the same in another currency according to the exchange rate at that time.
When we look at this in practice, we find that the same ‘basket of goods’ does not cost the same from country to country. Therefore, the measure compares what a basket of goods actually costs in one country compared to another. In this way, PPP shows us whether different currencies are under or overvalued.
The World Bank compares purchasing power parities across different global economies. The 2017 report offers a valuable resource in economic indicators showing the state of the global economy prior to the COVID-19 global pandemic. While this report found that China and the United States were the two largest economies in the world, East Asia and Pacific and Europe in central Asia were the two largest regional economies (Fu & Hamadan 2020).
While foreign market exchange rates are useful when we compare investment flows trade and foreign currency reserves, they do not provide a useful measure on the spending power and material well-being of the inhabitants in a particular country. This is where PPP becomes more useful.
Fun fact!
Did you know that the United Nations uses the PPP to indicate how well countries are progressing against the Sustainable Development Goals? They provide useful insight in terms of a country success at achieving No Poverty (SDG1) and Zero Hunger (SDG2), for example (World Bank 2019).
Knowledge check
Complete the following task.
Key takeouts
Congratulations, we made it to the end of the fourth topic! Some key takeouts from Topic 4:
- The foreign exchange market is where a currency is bought, sold and exchanged through an international network of brokers and traders.
- Exchange risk is the threat of business loss that may happen because of currency fluctuations.
- A company can protect itself against exchange risk through risk avoidance, risk adaptation, risk transfer or diversification.
- To compare living standards and economic productivity between different countries we can utilise a macro-economic measure called purchasing power parity, which assumes that the same 'basket of goods’ should be worth the same thing in all countries.
Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time, you can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then click 'Join' to enter the class.
Click here to access your seminar.
The learning tasks are listed below, these will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
In-seminar learning tasks
The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.
To further our ability to compare different countries’ financial markets, we will look at the Big Mac Index. This builds on your understanding of exchange rates and purchasing power parity (PPP). Your lecturer will facilitate a task that you will undertake as a breakout team.
Developing your research on individual countries, let us see if we can produce some useful comparisons as a class. Be prepared to share your individual findings from the discussion forum, as well as anything you have noticed when you compare your own findings with those from fellow students and the different market data they presented on the forum.
Welcome to your post-seminar learning task for this week. Please ensure you complete the task after attending your scheduled seminar with your lecturer. Your lecturer will advise you if any of these are to be completed during your consultation session. Click on the following heading to read more about the requirements for your post-seminar learning task.
Ensure you review the concepts covered and ask your lecturer any questions you may have if you do not understand something or are unclear on how to link this to your third assessment.
Each week you will have a consultation session which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time, you can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then click 'Join' to enter the class.
Click here to access your seminar.
Should you be unable to attend, you will be able to watch the recording which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
The International Comparison Program (ICP) is a World Bank initiative that compares 176 economies in terms of purchasing power parities (PPP), based on the gross domestic product (GDP). This index provides useful insights into different global economies.
References
- Collinson, S, Narula, R, Rugman, A & Qamar, A 2020, International Business, 8th edn., Pearson Publishing.
- Fu, H & Hamadeh, N 2020, New results from the International Comparison Program shed light on the size of the global economy, World Bank, https://blogs.worldbank.org/opendata/new-results-international-comparison-program-shed-light-size-global-economy?token=b6827c8c6191327b728245ab1a2d8d84
- Ganti, A 2020, Foreign exchange market, Investopedia, https://www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp
- Investopedia, 2020, Forex Market Basics Video, Investopedia, streaming video, YouTube, https://www.youtube.com/watch?v=Ah1fEYjR-1Q
- IMF 2020, Analyse this! Sovereign debt, streaming video, YouTube, https://www.youtube.com/watch?v=dwVx6mVDrZU
- Oner, C n.d., How economies function: inflation, prices on the rise, International Monetary Fund, https://www.imf.org/external/pubs/ft/fandd/basics/30-inflation.htm
- World Bank 2019, The 2030 sustainable development agenda and the world bank group: Closing the SDGs financial gap, https://thedocs.worldbank.org/en/doc/259801562965232326-0270022019/original/2030Agenda2019finalweb.pdf
