Due to the process of globalization small and medium sized business are increasingly finding themselves engaged in international finance. What can smaller businesses without an entire finance office do to both engage in international trade and protect themselves from adverse movements in the exchange rate?
Student 1:
A small business is not precluded from international trade even if it does not have a proper finance office. One way for a smaller firm to engage in international trade involves forming a joint venture with another small firm. Often times the small business looking to expand trading capability will engage with another firm that is already established in a foreign market.
A joint venture also allows each firm to enjoy the comparative advantages of one another. Another method of penetrating foreign markets for smaller firms involves franchising. McDonalds for example, purchases the land and building while a franchiser is in charge of hiring a staff, controlling costs, and executing the companys business strategy. A direct foreign investment is often necessary to franchise, which would make this method of expanding trading capabilities more costly than forming a joint venture. Small firms can also acquire existing operations in foreign markets to engage in international trade. This too is a more costly approach than forming a joint venture.
There are multiple ways that a smaller firm can protect themselves from exchange rate risk. Derivative contract such a forward contract, allows a firm to make an agreement with another party that the currency to be exchanged, the exchange rate, and the date of the transaction all have specified values. In essence, the firm will be locked into the current exchange rate at the signing date of the contract. Future contracts allow for an agreement where a standard volume of a particular currency is to be exchanged at a specified date. Options contract are another type of derivative that are often used to hedge futures payables. A call option provides an individual with the right to buy a particular currency at a strike or exercise price within a specific time period.
Student 2:
Smaller business without an entire finance office can engage in international trade and protect themselves from adverse movements in the exchange rate by engaging in the Spot Market where immediate foreign exchange transactions can take place. The exchange rate can be applied when one currency is traded for another including making commercial transactions. These transactions can be completed electronically with banks and other financial institution serving as intermediaries. Historical exchange rate movements can also be monitored through a website called Oanda that is free to use through the public to see exchange rates for different global currencies. In a spot market, currencies are categorized by their liquidity, that reflects the level of trading activity, the more liquid a currency is, the more it is heavily traded frequently.
Although shifts in exchange rates can affect the profit margins for smaller businesses, a few strategies to mitigate these risks is to require payments to be in dollars, require prompt payments, or charge more, or you can hedge by buying a spot contract. There are pros and cons to each strategy, ultimately, making the right decision can result in higher profit margins over time or overall affect your business strategies. Requiring payments in dollars can put the party making the payments to bear fluctuations, but it can more difficult to do business in that country. Requiring prompt payments to avoid changes in exchange rates can mitigate exchange risks. Charging more for your goods depending on a countrys currency fluctuation can help you increase profit, or breakeven if the currency rate drops.
