Global Financial Management (HSC SSCE Business Studies): Revision Notes
Global Financial Management
Global financial management involves strategies that businesses use to handle the financial risks and challenges that come with operating internationally. While global expansion offers economic opportunities, it also brings additional financial concerns that don't exist in purely domestic operations.
Understanding the risks in global financial transactions
When businesses operate globally, they face greater financial risks than those operating only within Australia. These risks are largely 'uncontrollable' because they stem from the external business environment. While businesses cannot control these external factors, they can implement financial management strategies to minimise negative effects.
Understanding Uncontrollable Risks
Global financial risks are considered 'uncontrollable' because they originate from external environmental factors beyond a business's direct control. However, this doesn't mean businesses are helpless - they can implement strategic financial management practices to minimise the negative impacts of these external forces.
Key risks in global financial transactions include:
- Currency fluctuations - changes in exchange rates between different currencies
- Interest rate variations - differences in borrowing costs across countries
- Payment security - ensuring you receive payment from overseas customers
- Exchange rate movements - unpredictable changes that affect the value of international transactions
Although global financial risks are greater than domestic risks, businesses must accept this increased risk to successfully implement international business strategies. Major financial institutions offer specialised services to help businesses manage these global financial challenges.
Exchange rates
What are exchange rates?
Each country uses its own currency for domestic transactions. When business occurs internationally, one currency must be converted into another. This conversion happens through the foreign exchange market (commonly called forex or fx), which establishes the price of one currency relative to another.
The foreign exchange rate is the ratio that shows how much one unit of currency is worth in terms of another currency. For example, if A$1 = $0.70, one Australian dollar is worth 70 US cents. Conversely, one US dollar would be worth approximately $1.43.
Exchange rate dealers worldwide constantly buy and sell currencies, which determines each currency's value in the global marketplace. This continuous trading means exchange rates are constantly fluctuating based on market forces of supply and demand.
Currency fluctuations and their effects
Exchange rates continuously change due to variations in supply and demand. These fluctuations create significant risks for global businesses.
Appreciation occurs when the Australian dollar's value rises against another currency. For example, if the Australian dollar rises from $0.70 to $0.95, this is appreciation.
Impact of appreciation:
- Each unit of foreign currency buys fewer Australian dollars
- One Australian dollar purchases more foreign currency
- Australian exports become more expensive on international markets
- Import prices fall
- Australian exporting businesses lose international competitiveness
Depreciation is the opposite - when the Australian dollar's value falls against another currency.
Impact of depreciation:
- Each unit of foreign currency buys more Australian dollars
- One Australian dollar purchases fewer foreign currency
- Australian exports become cheaper internationally
- Import prices rise
- Australian exporting businesses improve their international competitiveness
Worked Example: Understanding Exchange Rate Impact
Consider an Australian exporter selling wine to the UK for £10,000.
Scenario 1 - Before appreciation:
- Exchange rate: A$1 = £0.50
- Revenue in Australian dollars: £10,000 ÷ 0.50 = A$20,000
Scenario 2 - After appreciation:
- Exchange rate: A$1 = £0.60 (Australian dollar has appreciated)
- Revenue in Australian dollars: £10,000 ÷ 0.60 = A$16,666.67
Result: The appreciation has reduced the exporter's revenue by A$3,333.33, demonstrating how currency movements directly impact profitability.
Currency fluctuations significantly affect the profitability of global businesses. When transferring revenues and expenses between nations, exchange rate movements can either increase or decrease their value, directly impacting the business's ability to meet financial objectives.
Exam Tip
When analysing exchange rate impacts, always consider the perspective - whether the business is an exporter or importer - as currency movements affect them differently. Appreciation helps importers but hurts exporters, while depreciation helps exporters but hurts importers.
Interest rates in global operations
Businesses expanding internationally or increasing export production typically need to raise finance. Global businesses can borrow from Australian financial institutions or from overseas financial markets.
Australian interest rates have traditionally been higher than those in countries like the United States and Japan. This creates a temptation for Australian businesses to borrow from overseas sources to benefit from lower interest rates.
The Risk with Overseas Borrowing
Even though overseas interest rates may initially appear cheaper, adverse currency fluctuations can quickly eliminate any advantage. In the long term, 'cheap' overseas interest rates may actually cost more once exchange rate movements are factored in. Changes in interest rates significantly impact profitability for businesses with overseas debt.
Recent Context
In November 2020, the Reserve Bank of Australia (RBA) reduced the cash rate to a record low of to support the Australian economy during the pandemic. Australian interest rates averaged between 1990 and 2020, reaching a high of in January 1990.
Methods of international payment
Selecting an appropriate payment method is crucial in global financial management because non-payment is a very real risk for exporting businesses.
The international payment challenge
Payment complications arise because businesses may be dealing with parties who:
- They have never met
- Speak different languages
- Use different monetary systems
- Operate under different legal systems
- May be difficult to pursue if problems occur
The Payment Dilemma
The exporter's dilemma: If products are shipped before payment is received, there's no guarantee the importer will pay.
The importer's dilemma: If payment is sent before products are received, there's no guarantee the exporter will send the goods.
To solve this trust problem, international transactions typically involve a third party - usually a bank - acting as an intermediary. Both parties trust the bank to facilitate fair payment and delivery.
The four main payment methods
The chosen method depends largely on the importer's creditworthiness - their ability and likelihood to pay. Each method carries different levels of risk for the exporter.
Risk hierarchy (from least to most risky for exporters):
| Method | Risk Level |
|---|---|
| Payment in advance | Least |
| Letter of credit | Low to moderate |
| Bill of exchange | Moderate |
| Clean payment | Most |
Payment in advance
Payment in advance allows the exporter to receive payment before arranging for goods to be sent. This method exposes the exporter to virtually no risk and is commonly used when:
- The buyer is a subsidiary of the exporter
- The buyer's creditworthiness is uncertain
However, few importers accept these terms because it exposes them to maximum risk. They have no guarantee of receiving what they ordered.
Letter of credit
A letter of credit is a document that a buyer requests from their bank, guaranteeing payment will be transferred to the seller. The importer's bank issues the letter to the exporter, promising to pay a specified amount once certain conditions are met.
How a Letter of Credit Works
Step 1: The importer requests a letter of credit from their bank
Step 2: The bank issues the letter to the exporter, guaranteeing payment
Step 3: The exporter must present necessary documents proving shipment
Step 4: Once conditions are met, the bank pays the exporter
Step 5: If the buyer cannot pay, the bank must cover the purchase
Banks only issue letters of credit when confident the buyer will pay. They may require the buyer to deposit funds or use a line of credit.
Advantages for Exporters
This method is very popular with exporters because it relies on the overseas bank's guarantee rather than just the importer's promise. Only payment in advance offers less risk.
Bills of exchange
A bill of exchange is a document drawn up by the exporter demanding payment from the importer at a specified time. This widely-used method allows the exporter to maintain control over goods until payment is made or guaranteed.
Two types exist:
1. Document (bill) against payment
- The importer can collect goods only after paying for them
- The exporter draws up the bill with their Australian bank
- Documents allowing goods collection are sent to the importer's bank
- The importer's bank releases documents only after payment
- Funds are then transferred to the exporter's bank
2. Document (bill) against acceptance
- The importer may collect goods before paying
- The importer must sign acceptance of goods and bill terms
- Documents are released immediately
- Payment occurs at a later agreed date
- This exposes exporters to greater risk
Risk Comparison
Bills of exchange carry greater risk than letters of credit. Documents against acceptance expose exporters to much higher risk than documents against payment, as there's risk of delayed payment or non-payment.
Clean payment
Clean payment (open account payment) occurs when the exporter ships goods directly to the importer before receiving payment. The importer doesn't send payment until after receiving the goods.
How it works:
- Goods are shipped with an invoice requesting payment
- Payment is typically due , , or days after delivery
- This timeframe is called the credit term
This method is used only when the exporter is confident the importer will pay by the agreed time. It's the riskiest option for exporters but the most advantageous for importers.
Exam Tip
Questions may ask you to recommend a payment method. Consider the relationship between parties, creditworthiness of the buyer, and balance of risk between exporter and importer.
Hedging strategies
When parties exchange currency immediately, the transaction is called a spot exchange. The spot exchange rate is the value of one currency in another currency on that particular day.
While spot rates are sometimes necessary, they may not be the most favourable rate. Currency fluctuations cause real concern because they can increase costs and reduce profits.
Hedging is the process of minimising currency fluctuation risks to reduce uncertainty in international financial transactions.
Natural hedging
Businesses can adopt various strategies to eliminate or minimise foreign exchange exposure without using financial products. These natural hedges include:
Establishing offshore subsidiaries - operating directly in the foreign market reduces currency conversion needs.
Matching currency payments - arranging import payments and export receipts in the same foreign currency. Losses from exchange rate movements in one direction are offset by gains in the other.
Reducing price sensitivity - implementing marketing strategies that make exported products less sensitive to price changes caused by currency fluctuations.
Denominating contracts in Australian dollars - insisting that both import and export contracts use Australian dollars. This transfers the exchange rate risk to the buyer (importer).
Natural hedging strategies offer the advantage of avoiding the costs and complexities associated with financial derivatives while still providing effective protection against currency risk. These approaches integrate risk management directly into business operations.
Financial instrument hedging
Beyond natural hedges, financial institutions offer increasingly sophisticated financial products called derivatives to minimise or spread exchange rate risk.
Derivatives
Derivatives are financial instruments that may be used to reduce exporting risks associated with currency fluctuations. Understanding derivatives is similar to understanding fixed interest rate loans - both allow you to lock in a rate to protect against unfavourable movements.
How Derivatives Work - An Analogy
With a fixed interest rate loan, you lock in a rate to protect against future interest rate rises. This helps with financial planning because you know exactly what you'll repay. The disadvantage is you can't benefit from falling interest rates.
Similarly, derivatives allow businesses to lock in exchange rates for future transactions, providing certainty but potentially missing out on favourable rate movements.
Important Warning
Derivatives can be as dangerous as the risks they're supposed to protect against if used unwisely. Proper understanding and strategic implementation are essential for effective risk management.
Forward exchange contracts
A forward exchange contract is a contract to exchange one currency for another at an agreed exchange rate on a future date, usually after , , or days. The bank guarantees the exporter a fixed exchange rate for money generated from exported goods sales.
Worked Example: Forward Exchange Contract
Imagine a business sells $ worth of products to a Japanese customer, with payment due in days. The business can lock in the currency value by:
- Selling Japanese yen and buying Australian dollars
- At a fixed rate
- To be settled when the invoice is paid
This locks in the sale's value regardless of exchange rate movements during the days.
Benefit for Small and Medium Exporters
Many small- to medium-sized exporters hesitate taking large orders due to exchange rate concerns. Forward contracts remove this uncertainty, allowing businesses to confidently accept large international orders.
Options contracts
An option gives the buyer (option holder) the right, but not the obligation, to buy or sell foreign currency at some time in the future.
Key advantage:
Option holders are protected from unfavourable exchange rate fluctuations while maintaining the opportunity to benefit from favourable movements. This flexibility makes options attractive but typically more expensive than forward contracts.
Swap contracts
A currency swap is an agreement to exchange currency in the spot market with an agreement to reverse the transaction in the future. It involves:
- A spot sale of one currency
- A forward repurchase of the currency at a specified future date
Example: Swapping $ million Australian dollars for US dollars now, with an agreement to reverse the swap in three months.
Practical Application: Currency Swap
Australian businesses use currency swaps when raising finance in countries where they're not well-known. A medium-sized Australian business needing Japanese yen might:
Step 1: Borrow Australian dollars in Australia (where it's well-known and gets better rates)
Step 2: Find a Japanese business needing Australian dollars
Step 3: The Japanese business borrows yen in Japan (where it gets better rates)
Step 4: They swap currencies
Step 5: Each business repays the other's loan
Main advantage: Swap contracts allow businesses to alter their exchange rate exposure without discarding the original transaction.
Case study insight: Airlines and fuel hedging
Airlines face significant fuel cost volatility, which greatly affects profitability. To mitigate risks from unpredictable fuel prices, airlines commonly practice fuel hedging using forward contracts.
When airlines enter forward contracts, both parties give up potential profits for certainty. At contract maturity, one party 'wins' and one 'loses' depending on whether market prices moved favourably or unfavourably compared to the contract price.
Remember!
Key Points to Remember:
- Global financial risks are greater than domestic risks but manageable through appropriate strategies
- Currency appreciation makes Australian exports more expensive and less competitive internationally
- Currency depreciation makes Australian exports cheaper and more competitive internationally
- Payment method selection depends on creditworthiness - riskier importers require more secure payment methods
- The risk hierarchy for exporters runs from payment in advance (safest) to clean payment (riskiest)
- Hedging protects against currency fluctuations through natural strategies or financial derivatives
- Derivatives include forward exchange contracts, options contracts, and swap contracts
Key Terms:
- Foreign exchange market (forex) - market determining currency prices
- Appreciation - upward currency movement
- Depreciation - downward currency movement
- Letter of credit - bank guarantee of payment to exporter
- Hedging - minimising currency fluctuation risks
- Derivatives - financial instruments reducing currency risk
- Spot exchange rate - currency value on a particular day
Critical Understanding:
Exchange rate movements directly impact business profitability. Businesses engaged in global trade must implement appropriate financial management strategies to minimise risks while maintaining competitive positioning in international markets.