Navigating International Business Expansion

1.0 Introduction

In the current globalised business environment, internal expansion of businesses has come a common phenomenon. In fact, internalisation in the context of business organisations are no more viewed as an option rather it is regarded necessary for the success and profitable survival of the business. The phenomenon of internalisation has offered businesses with numerous opportunities such as creating demand for the organisations’ products and services beyond the domestic market of their operation and generates increased revenue by capturing substantial base of national and international customers. Nevertheless, attaining successful expansion of the business in the international arena is argued to be imposed with several risks and challenges (Hashim, 2012; Kontinen & Ojala, 2012). More specifically, the businesses that are planning to expand their business internationally are argued to face with several financial, and cultural risks and challenges which often deters business to undertake their expansion strategy and in certain cases, such endeavour are also argued to result in heavy financial losses. It is thus crucial for the business and firms planning to expand their business internationally to conduct a risk assessment before the implementation of the international expansion strategy to avoid any financial and cultural impact on their business (Hashim, 2012).

Against this backdrop, this report aims to presents memorandum outlining how the derivatives would help business to manage risks concerning the Ealing-based manufacturing company that deals with high-quality “London-yellow” bricks.

2.0 Key Risks of Associated with International Expansion of the Business

It has been observed that the business has been doing well in the last few years and was able to achieve £ 5 million as its annual turnover in its previous fiscal year. At the same time, it is anticipated that the business will be able attained steady growth of 5% in the sales of its operation in the UK. At the same time, the net profit merging for the businesses is ascertained to be just 5%. It is quite apparent that the performance of the business has remained positive in its domestic market. Despite the fact that the business has been able to perform well in its domestic market, there is a high possibility that it might have to face certain challenges it its course of international expansion. Some of the common challenges that it might face as a result of international expansion can be related to lack of its expertise in operating in cross-culture business environment and differences in the culture. Although, these factors may have a substantial impact on the international expansion of the business, the major risks that it can encounter can be related to foreign exchange risks. It is vital to note that in the light of globalisation and the rapid internalisation of the business, the foreign exchange risks has emerged as one of the most persistent problems faced by the business planners and executives (Al-Momani & Gharaibeh, 2008). In this context, it can be argued that though foreign exchange rates have the potential to undermine the profitability and competitiveness of the exporting firms significantly, it also offers a comparative advantage to the home country. Since the report primarily intends to determine the key risks associated with the international expansion of the business, it would be ideal to focus on the challenges and risks foreign exchange rates.

Notably, it has been observed that fluctuating exchange rates tends to pose unique risks for the business as it sets to develop global supply chain with the objective to expand its business internationally. In this regard, in a situation where there is sharp fall of the domestic currency as an outcome of exchange rate fluctuation, it is observed have a significant impact on the business. Accordingly, such outcome is recognised to cause significant variability across various dimensions of the business including cost, revenue, competitiveness, profitability and shareholder value. On the other hand, when there is strong Sterling, it may initially have some advantage in the form of stronger purchasing power, but it would eventually culminate in eroding the hard earn competitiveness of the business as this would result in fall in the demand for its product and would dampen the favourable impact of the depreciation on exports (Malik, 2016). Notwithstanding, exchange rate risks posed to the business as a result of its international expansion can be further categorised into three different types and categories. In this regard, the exchange rate can be classified as transaction risk, translation risk and economic risk. The transactional risk is primarily a risk associated with cash flow, and it mainly deals with the impact of the exchange rate that arises from transactional account exposure related to receivables, payables or due to the repatriation of dividends. In other words, any change in exchange rate results in the changes in the current and anticipated cash flows of foreign currency, which is recognised to have posed a direct risk to the firm (Bogićević, 2016). On the other hand, translation risks are predominately associated with the balance sheet risks, which arises when foreign assets and liabilities held by the business are required to be reported in the home c currency denomination. Likewise, economic risks are related to the effect of exchange rate on the firm competitiveness (Papaioannou, 2006).

3.0 Presentation of Key Derivatives That Can Be Used In Managing the Above Risks

As noted above, exchange rate risks are associated with the impact arising from unexpected changes in the exchange rate regarding the value of the business. Correspondingly such impact has the tendency to incur a direct or indirect loss to the business on its cash flow, net profit and assets and liabilities. To manage these exchange rate risks, it is important for the business to determine the most appropriate strategies and instruments.

In this regard, financial hedging strategies that encompass derivative instruments are recognised to offer the business with suitable tools to manage the risks. Accordingly, four key derivative instruments can be used to deal with the above risks that include:

Forwards and futures

Forward and future are often discussed in a combining form as these two derivative instruments share similar characteristics. Accordingly, forward exchange rate contracts are regarded as the most direct method to reduce the transaction exposure. It is an agreement to buy or sell a certain quantity of foreign assets at a known future date and at a specified rate agreed today. On the other hand, future contract is exchange traded similar to forward but is standardised (Chui, n.d.).

Options

Option contract entitles one party the right to buy or sell a certain amount of foreign currency at a given exchange rate on or before the agreed date. However, it is worth to note that the option contracts by no means create an obligation to any of the parties (Kelley, 2001).

Swaps

Swaps are the agreements amid the two counterparties regarding the exchange of cash payments for a particular period. These periodic payments are usually charged either on fixed or floating interest based on the terms of the contracts. Notably, these payments are calculated based on the specified amount which is a notional principal or simply notional.

4.0 Critical Analysis of Warren Buffet Words and Their Applicability to This Case

In 2002 Warren Buffet in his report to Berkshire Hathaway shareholders wrote that “I view derivatives as time bombs, both for the parties that deal in them and the economic system… In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.

The statement of Buffet was based on several factors and limitations associated with the use of derivative contracts. Correspondingly, he noted that derivative contracts are not based on specific terms of the period rather their duration varies significantly and can extend to 20 or more years (Stulz, 2004; Buffett, 002). Also, derivatives are viewed to strongly related to several other variables while it has also been argued that the derivatives are often overstated. At the same time, he claimed that since the derivatives are based on estimates, the inaccuracy associated with such estimates is largely remained unexposed for several years. Moreover, he contended that parties associated with derivatives enjoy significant incentives to engage in deceptive practices. In this regard, he notes, that those who are engaged in the derivative trades are paid either partly or wholly on the entire earnings which are calculated based on mark-to-market accounting, but he strongly contended that in fact there exists no real market. By this Buffet implies that the trading of derivatives largely profits CEO unit the shareholders realised that the reported earnings were deceptive (Stulz, 2004; Buffett, 002).

Although several scholars and experts have criticised the use of financial derivatives as a tool for exchange rate risk management, given the Buffet’s statement of derivative, it would be impractical to compare derivatives with bomb or weapon of mass destruction. This is because financial derivative instruments not only have its drawbacks but it also presents significant benefits to the firms in the current business environment that are characterised by uncertainty and volatility. In this regard, it can be argued that the financial derivative instruments such as forward contracts, futures, options, swaps are effective instrument that enables the firms in the current highly dynamic and competitive market to transfer risk to those agents who are in better position to bear the risks or are willing to take risks, which in turn reduces the risks for the firms (Malleswari, 2013). Besides, derivatives instruments not only aid firms to hedge risks but it also contributes to building speculative stance in the financial markets. Besides, it also reduces the adverse impact on the competitiveness arising from currency movements and allows firms to undertake competitive pricing in a given market without reducing the margin. In this regard, it is worth to note that maintaining a fair level of margin is one of the important strategic requirements for any business firms. On a further note, use of derivatives is allowed firms to attain economies of scale which makes the firm’s competitive factor crucial in the long run (Brown, 2001).

Evidently, a study conducted by University of Pennsylvania during the year 2000-2001, it was found that derivatives play an instrumental role in reducing the exchange rate risk exposure. To be price, derivative instruments have the capacity to neutralise the adverse effects on the market share which in turn allows firms to overcome the risk posed by the changes in the exchange rates (Culp, 2004).

Thus, based on the critical analysis of the Buffet’s word on derivative, it can be stated that the business in the given case should place little importance on Buffet’s words and it should not fear to use derivatives. In other words, it should apply financial derivative instruments to manage the risk arising from its international expansion effectively. Through these instruments, it can neutralise the risks by establishing counterbalancing positions. The application of these derivative instruments is more likely to allow the business to sell the inflow of Rupee and Yuan which it will be expecting through its international expansion at a known future date. This will reduce the foreign exchange rate risk exposure for the business. Besides, the net profit margin of the business is only 5% and therefore to maintain fair margin, it would be ideal for the business to use the derivative instrument to deal with the economic exchange rate risks.

5.0 Conclusion

In conclusion, the report presented that key risks associated with the international expansion of the given business. In this regard, exchange rate risks such as transaction risks, translation risks and economic risks were recognised to significant impact on the given business as a result of its international expansion. To effectively manage and deal with these risks, four financial derivative instruments were ascertained that include forward contract, future contracts, option and swaps. On further note, the critical analysis of the Buffets words on derivative demonstrated that Buffet has been quite impractical in his conclusion, and his views were largely based on the limitation of derivative instruments while he can be found to ignore the effectiveness of derivative instruments in promoting stability, reducing exchange rate risks on net profit and the competitiveness of the business. Thus, the business in the given case should pay little attention to the Buffet’s word instead the business should apply derivative instruments to reduce exchange are risk exposure and to maintain a fair level of its net profit margin.

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References

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