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Risks in international transactions: Typology and impact


1.1. General Considerations

The acceptation most often used defines risk as the probability of appearance of certain
events that have negative consequences on the economic activity, that is the events which, in
case of occurrence, would generate economic-financial damages, unexpected additional
expenditures or would generate the partial or total lose of the expected profit.

The basic elements of the risk are:


• The possibility of deviation from the pursued goal;
• The probability of reaching the anticipated result;
• The uncertainty of reaching the anticipated result;
• The possibility of having material or moral losses as a consequence of the uncertainty
situation.

The risk can be characterized as follows:


 Contradictory – the risk assumption supposes the overcoming of
certain moral barriers that limits the implementation of projects; at the same time it
supposes a certain act of voluntarism and subjectivism.
 Alternative – it supposes the necessity to choose from 2 or more
variants of action (the renouncement to choose is considered to be as well a
decisional alternative). In case if there is no alternative, it is considered that there is
no situation of risk.
 Uncertainty – the risk is predetermined by an uncertainty.

The main causes of risk situation appearance are the following:


i. The spontaneity of natural processes
ii. Conflict of interests or the existence of opposed trends
iii. The probabilistic character of the Technical-Scientific Progress
iv. Insufficiency of information regarding the analyzed object or process
v. The non-concordance of the activity’s functional aspects (planning, supply, production
etc.).

1.2. Typology of risks


There exists a variety of risks; some of them have always existed, some have recently
appeared.
Risks can be classified according to:
A. Time of appearance →
 Retrospective: risks that affect the firm’s past transactions, but the event itself
occurs in the predictable future, the enterprise being exposed to the consequences
of the respective event;
 Current: risks that affect the current transactions of a firm.
 Perspective (future): risks that suppose events occurring in present, but affecting
the future decisions and actions of the firm.
B. Factor of appearance →
 Political: are determined by the social and political situation changes, it can have
negative consequences on the analyzed project, e.g. the protectionist policy of a
government;

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 Economic: are conditioned by the changes that occur in a firm’s or a country’s
economy, e.g. inflation trends, decreasing degree of financial solvency of a certain
enterprise etc.
C. The character of consequences →
 Pure: suppose the possibility of loss in entrepreneur activity; may be cause by
natural calamities, accidents, illicit actions. This category includes political,
ecological, natural, transport, commercial, production risks etc.
 Speculative: suppose the possibility of loss as well as of income surplus. Causes of
this type of risk can be fluctuation of exchange rate, the level of inflation,
modification of the fiscal legislation etc. It includes financial risks.
D. Their impact
 External: these risks are not determinable by the enterprise or by its suppliers,
competitors, employees etc.; they are determined by such factors as demographic,
social, political etc.
 Internal: conditioned by the activity of the enterprise or of its internal
environment. They can be determined by the firm’s strategy, financial or
production potential, level of productivity etc.
E. The domain of appearance →
 Commercial: appears in the process of commercialization of goods/services and
can be determined by the modification of market juncture (competition), change of
acquisition prices.
 Financial: the firm’s risk of not being able to meet the financial obligations
assumed towards the business partners. The main causes of this type of risk are
devaluation of the investment portfolio (as a result of the exchange rate
modification), decrease of the exchange indexes.
 Of production: risk of non-fulfillment of the production obligations assumed
towards the business partners due to the unfavorable impact of external and
internal factors. E.g. decrease of productivity level, increase of material costs,
unstable supply services, defective equipment etc.
 Of insurance: risk of payment of compensations for the registered losses as a
result of an insured event occurrence. This risk is determined by the correctness of
possible impact estimation etc.
F. The exposure degree →
 Small
 Medium
 Big
G. The nature of events causing the exposure to risk →
 Business risks: the risk inherent to the performance of any economic activity. It
represents the possibility of registering losses as result of: 1) unfavorable economic
conditions (recession, decrease of consumers’ income, business volume decrease
etc.), 2) launch of non-viable products on the market, 3) market structure
modification as a result of new products or new competitors emergence, 4)
consumers’ preferences changes, 5) bad management of enterprise, 6) inadequate
planning etc.
 Financial risks: the risk associated with the occurrence of certain unfavorable
financial events, like unfavorable changes in prices and liquidity on the financial
and commodity markets; the counteragents’ insolvency; worsening of
counteragents’ financial reliability etc.
 Operational risks: the exposure to unforeseen losses or expenses as a result of
deficiencies in the information system or in its administration, in management of

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human resources and technological processes, as well as in proceedings of internal
control.
 External events risks: exposure to losses caused by the unfavorable modification
of the business environment in which the firm and its counteragents perform their
activity, losses caused by the unfavorable changes in legal provisions, as well as by
unfavorable natural events.

1.3. Methods of coverage of economic and political risks

After identifying the size of the risk, the risk manager must examine all the methods of
risk management. There are two main categories of risk management methods:

1. Methods of minimizing the losses:

1.1. Deviation from risk

1.2. Prevention of losses

1.3. Minimization of losses

1.4. Search of information

2. Methods of compensation of losses

2.1. Risk assignment

2.2. Risk control assignment

2.3. Risk allocation

2.4. Risk assumption

1. The methods of minimizing the losses include:

1.1. Deviation from risk: the commercial entity can simply avoid the activity causing the
respective risk. It is very difficult to eliminate entirely the possibility of losses, that is
why in practice deviation from risk means to not take the risk at a higher level than
usual. But, the continuous rejection of performing risky activities would lead the firm to
a stagnation of the business activity and thus would reduce considerably the profit.

1.2. Prevention of losses: the enterprise can try to reduce but not to fully eliminate certain
losses. Prevention of losses represents the possibility to preserve from fortuities by
taking preventive measures, that is measures directed to prevent unforeseen events in
order to reduce the possibility and size of losses.

One of the methods of loss prevention is considered to be reporting. It represents


the systematical documentation of all information related to identification and analysis
of internal and external risk, related to setting the residual risk after taking all the
measures for risk management etc. all this information must be registered in certain data
bases and in accounting documents, which are easily managed.

1.3. Minimization of losses: the commercial organization can prevent a considerable part of
losses. It can avoid additional penal sanctions in case of any incident occurring in its
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daily activity by keeping all the rules set by legislation. The methods of minimizing
losses include:

 Diversification – according to this method, the firm invests its


capital resources in various spheres, in order to compensate in case of loss in one
domain from another sphere. There are different types of diversification. For the
commercial enterprises the most common types are: diversification of the economic
activity; diversification of different development projects; diversification of
investments; diversification of suppliers’ portfolio, of consumers’ portfolio, of
securities’ portfolio.

 Limitation/salvo – setting limit of expenses, of sales, of credit etc.


limitation can be used by the commercial enterprise in selling through credit, in
lending to other firms or to its employees, in determining the value of the capital
investment etc.

The setting of the quota’s size represents a multi-step procedure, including the
setting of the quotas list, the size of each quota, their analysis and their legislative
authorization.

 Creation and functioning of a quality system – the quality system


includes:

 Quality maintenance

 Quality management

 Quality planning

 Quality improvement

The modern quality system encompasses marketing, market research and study,
material-technical supply, transportation of goods taking into account the goods’
quality maintenance, sales and after-sales services etc. The quality system reduces
the general expenses for quality, improves the management efficiency, makes more
efficient the response to clients’ demands, thus increases the volume of sales and the
size of income. As a result, the entities that have a high level quality management are
more attractive for foreign investors.

 Search of information – this is a method directed at risk reducing


through the identification and usage of the information necessary for the risk
decision taking by the commercial entity.

Usually the wrong decisions taken are determined by the lack or insufficiency of
information. The asymmetric property of information, that is when separate
participants on the market have access to important information while other
participants don’t, is a serious impediment for economic subjects to act reasonably
and represents a barrier in using efficiently the resources and means. At the same
time, the obtaining of the necessary information and increase of the information’s
providing level can considerably improve the forecast and reduce the risk. In order to
determine the quantity of the necessary information and the expediency of obtaining
it, it is necessary to compare the expected benefits this information might bring and

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the expected expenses related to its purchase. If the expected benefit is above the
expected expenses, this information is obtained and vice versa.

2. Methods of loss compensation (having minimum costs) are used in the case if the company
has losses in spite of all the efforts taken for their minimization.

2.1. Risk assignment – the firm may prefer to cover the losses from the capital obtained from
external sources. Most often the assignment of risk to other economic agents takes place
through hedging or insurance.

a) Hedging – is the system of concluding a futures


contract, taking into consideration the possible future price changes, and is aimed at avoiding
negative consequences of these changes. The essence of hedging results in the simultaneous
purchase/sale of Futures and sale/purchase of contracts at sight with the same time of delivery.
This way the changes in price are balanced. In the market economy hedging is widely used for
the risk reduction.

The contract having the role of insurance against the risk of price changes is called hedge,
and the person performing a hedging operation is called hedger. Depending on the technique
of realization, there are two types of hedging:

Long hedging (hedging for increase, purchase hedging) represents an exchange transaction
of purchasing term contracts (forward, options and futures). Long hedging is used in cases
when it is necessary to be insured against a possible future increase in price. It allows setting
the purchasing price much earlier than the real asset is bought.

Short hedging (hedging for decrease, selling hedging) represents an exchange transaction
of selling term contracts. It is used in cases when it is necessary to insure against a possible
future fall in prices.

Hedging can be performed through transactions with futures, options and forward
contracts.

Hedging to some extend determines the decrease of the risk caused by unfavorable price
changes, but it does not allows benefiting of the favorable price changes. In the process of
hedging the risk does not disappear, it just passes to other participant of the transaction: the
commercial company transfers the risk to the exchange speculator.

b) insurance – is the method directed at reducing the risk by transforming the unexpected
damages into relatively permanent expenses. By concluding an insurance agreement, the
commercial company transfers the risk to the insurance company, which compensates different
damages caused by unfavorable events, through payment of the insurance compensation and the
insurance sums. For being provided these services the commercial enterprise must pay to the
insurance company an honorary called the insurance premium.

There are insurable and non-insurable risks.

Non-insurable risk is the risk that no insurance company will agree to cover, due to the fact
that the possibility of its occurrence and the losses’ size are unpredictable. Risks related to

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possible government action or to general economic modifications, are rarely insured by
insurance companies. Certain non-insurable risks are transformed into insurable ones if there is
accumulated enough information necessary for the precise evaluation of the eventual losses.

Insurable risk is the risk the insurance company can cover as the possibility of its
occurrence and the size of losses caused are easily predicted.

The risk transfer from the insured company to the insurer is possible only in the case if
both parties consider that the resulting effect would exceed the agreement expenses. At the same
time each party evaluates in its own way the profitability of the respective deal.

For the commercial enterprise the benefit of insurance results in the decrease of the risk
level and in the possibility to transfer the potential losses to the insurance company. Still, it may
happen for the insured event to not occur, meanwhile the insurance premium must be paid at the
moment of agreement concluding in any case. This way, the pure effect of the insurance
agreement, for the commercial company, depends on the level of evaluation of the insurance
benefit in comparison with the real expenses related to the insurance agreement. In this case the
role of subjective factors is considerable, that is why the same risk can be insured by one
commercial company and not insured by another.

For the insurance company the benefit of the insurance agreement refers to the premiums
it gets. The loss results in the payment of the insurance compensation at the moment of the
insured event occurrence. The insurance company can take the risk if it evaluates the benefit as
exceeding the losses related to the risk transfer. On the other hand, the evaluation is determined
by certain subjective factors and it depends on the content of its insurance portfolio.

The insurance manager has another alternative – to transfer the risk not to one insurance
company but to several insurance companies simultaneously. This represents co-insurance.

Co-insurance represents a type of insurance according to which two or more insurers


participate with proportional shares in insuring one risk, concluding a common insurance
agreement, which stipulates the share of risk each company takes. The object of co-insurance
either has a high value or is under high risk of being damaged due to unfavorable natural
conditions.

The advantages of co-insurance are reflected in the fact that its utilization allows the
insured person to diversify the insurers’ portfolio; to decrease the losses caused by non-payment
of insurance compensation as a result of bankruptcy of the insurer; to benefit additional services
provided by other insurance companies.

The disadvantages of co-insurance are the following: first of all the problematic
cooperation with several insurance companies in insuring against one risk; second insurance
companies do not always have united responsibility; and finally many insurers don’t want to
participate in co-insurance as they are afraid of competition from other insurance companies and
because they do not want to share the insurance premiums.

Besides these, the risk manager must take into consideration the double insurance, that
supposes insurance at several insurers of the same object against the same risks, in case if the
insurance sum exceeds the asset’s insurance value.

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2.2. Risk control assignment – the commercial company can transfer the control over the
risk to a third person or to a group of persons by transferring:

 the real assets or business related to the respective risk;

 the responsibility for the risk.

The commercial company can sell its securities, in order to avoid the investment risk, or
any other type of asset, the proprietorship of which relates to a certain risk. It can assign its assets
(securities, immovable, financial resources etc.) for reliable management to professionals (trust
companies, investment companies, financial brokers, banks and others) thus assigning all the risks
associated to these assets and to their functioning. The enterprise can also transfer the risk by
assigning a certain domain of activity, or department; for example it can assign to the insurance
broker the function of identifying the optimal insurance compensation and the portfolio of the
insurers. The firm can hire another commercial company to deal with the realization of its
products, in order to reduce the risk of expenses’ increase associated to the realization of the
respective product. Factoring is another method of risk control assignment. By transferring the
business department related to cashing of clients’ debt to the bank, the commercial enterprise
assigns as well the credit risks associated to the possible non-payment of claims. Forfeiting also is
related to this method of risk reduction in case of firms doing business on foreign markets.

2.3. Risk allocation – it is a method which supposes to distribute the risk of the potential
damage among the transaction participants, so that the possible losses of each participant be small
(e.g. risk allocation among the firms participants at product’s realization). This method represents
the basis of the risk financing. Due to the utilization of the respective method, the financial-
production and production-commercial groups accept to finance large projects. Different
collective funds are based on this method.

The main principle of the risk financing is the division and allocation of risk on the basis
of: 1) preliminary accumulation of financial resources in common funds, which are not related to
a concrete investment project; 2) organization of the fund as partnership; 3) management of
several partnership-funds which are at different levels of development.

The funds of risk (venture) financing relate to managing separate enterprises as well as to
organizing individual risk investor-firms. The main goal of these funds is to support the starting
venture companies, which, in case of project’s failure, will take a part of the financial losses. The
venture capital is utilized for financing the latest technical-scientific researches, their
implementation, launch of new types of products, services providing, and are composed of
contributions of the individual depositors, large corporations, government bodies, insurance
companies, banks.

Another efficient method of risk control allocation represents the funding and participation
of commercial firms in mutual insurance communities (MIC). The mutual insurance community is
a non-commercial organization, created by construction, transportation, industrial and financial
corporations, where they join their capital with one reason – to insure their financial interests.
Every participant of such a community becomes both an underwriter and an insurer. MICs have a
series of advantages. They generally represent a form of organization of insurance funds on the
basis of the contribution participation of its members. They are created as societies with limited
liability or as cooperatives; they are juridical persons and are responsible for their liabilities with
their assets.

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1.4. Risk assumption – the commercial firm can take the risk in the following cases: If
the potential loss is insignificant; If the insurance expenses are too high; If the company has an
efficient management (which can reduce the risk); If there are no other alternatives of protecting
against a risk.

One method of risk assumption is self-insurance. It represents a mechanism through which the
firm is insuring itself by accumulating individually resources for covering different losses.

Risk assumption supposes that all the losses, generated as a result of the taken risk realization,
will be compensated by the firm. The firm’s own compensation possibilities result from:

a) Utilization of the current income

b) Creation of own special risk funds: the peculiarity of these funds results
in the possibility it gives to compensate the possible losses without disturbing the balanced
development of the enterprise. Depending on the purpose, they can be created in natural or
money form.

c) Obtaining a credit or loan for loss coverage: a small or medium sized


company is not always able to accumulate the necessary amount of financial resources for
covering catastrophic losses. In this case, the company is forced to take a credit or loan in
order to continue its activity.

d) Selling of a part of assets: this method is efficient only when the firm
has goods to sell without risking to lose financial stability and reputation.

e) Including small losses in the products’ and services’ price: it is


important to mention that this method should be used carefully, taking into consideration
the firm’s general price policy.

f) Obtaining an insurance compensation from the captive insurance


company: these are joint-stock companies created by large commercial companies. The
advantages of a captive insurance company are:

• Privileged insurance terms, offered to its mother-company;

• The possibility of mitigation of fluctuations in the level of losses on the basis


of the financial fund in the long run;

• Insurance, besides the mother-company, of other companies, and thus


obtaining additional financial flows;

• The direct access on the reinsurance market.

Many captive insurance companies are registered in off-shore zones, thus allowing to
avoid the hard law and fiscal control.

Self-insurance has also certain negative aspects. It allows the commercial company to
make use of financial resources in critical situations, but at the same time it has well-defined
economic boundaries, as the resources the company can deposit in the reserve or use for losses’
coverage, are not unlimited. In case of great losses the own resources are not enough for their
compensation, this fact leading to a possible bankruptcy or forced termination of the company.

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Besides these, self-insurance requires a qualified risk management and a professional
management of the risk funds created by the enterprise.