"A leader has a right to fail once in a while, but a leader does not have a right to be surprised."
©Risk Concern. All Rights Reserved. This work provides an in-depth discussion regarding economic, political, and currency risks, also providing appropriate responses to such concerns. These are critical factors that all managers/aspiring managers should understand.
In our previous work on investment risks, a central discussion regarding investment risks was provided. This work, however, discusses currency, economic, and political risks from the perspective of a business, also providing in-depth responses.
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How can currency risks be hedged internally or externally by businesses?
There are two options available to hedge currency risk broadly. These are internal and external methods/options that can be utilized to reduce risks, such as those related to transactions on purchases and sales. For businesses that transact internationally, concerns related to currency fluctuations, appreciations, and devaluations are critical.
Below, the most commonly used approaches are explained:
Internal hedging options for FX transactions
These include local currency invoicing, leading/lagging, and matching payments.
Invoicing in local currency for FX risk reduction
One of the simplest methods that can be applied is to request/ask trading partners, etcetera, to invoice in the firm's local currency. This is the simplest method to eliminate all currency fluctuation risk, as the trading partner would be required to pay in the home currency of the entity, i.e., a company based in the UK invoicing in GBP & a European one in EUR.
It may be even better to sign long-term contracts with trading partners (TPs), etcetera, in the firm's home currency. Such a move would mitigate the risk of currency fluctuations for the length of the contract. However, it is important to note that persuading all partners to invoice in the company's home currency would be challenging, as TPs may not be comfortable doing so (as they may have the same concerns regarding fluctuations/devaluations).
Furthermore, the firm may be in the direct-to-consumer business in multiple jurisdictions, and charging a consumer, say, in South Africa, for example, in USD, wouldn't be viable and may deter customers that cannot transact in the currency demanded. Nevertheless, where this method is potentially feasible, managers should at least try to implement it, as large TPs may oblige & accept the request.
Leading/lagging for FX payments
Management can also use the method of leading and lagging. For this approach, the manager(s) can examine the real interest rate in the trading partners' country and the firm's home country. For example, for a US-based entity trading with a firm in, say, Australia, for a deal to be completed within one year, the yield on 1Y US treasury bills minus the rate of inflation would be the real rate of interest; the same can be determined for the TP by subtracting the inflation rate from the yield on 1Y bonds in the country of the TP.
We can then use methods such as covered interest parity to determine whether the home country's currency will likely appreciate or depreciate in the future, in relation to TPs currency. This can be done by utilizing a simple formula: Future exchange rate = current exchange rate (foreign) × (real interest rate in foreign currency ÷ real interest rate in local currency).
An example: A US firm trading with a Japanese partner can determine whether the USD is likely to appreciate against the YEN, utilizing the above-stated formula, with an assumption of a local Interest rate (real) at 2% for US, 1.25% for Japan, & a current FX rate of 111.0000 USDYEN, in the following way:
111×(1.0125÷1.02) = 110.1900.
As per the covered interest parity formula results, we can conclude that the USD, in this hypothetical example, is likely to decline against the YEN, & as such, we may want to lead the payments. If we believe (utilizing our numerical analysis) that the home country's currency will depreciate, we can make our payments now; we can also make payments for next year's purchases presently, to protect ourselves against such depreciation. However, if we determine that home currency is likely to appreciate, we can lag our payments; for example, we can delay as much as possible to benefit from the currency movement in our favor, i.e., the depreciation of the trading partners' currency.
Nevertheless, early payments cost a company interest forgone on the funds paid early. If we delay/lag payments, the payee would not be happy, and the relationship may be negatively impacted as well. Furthermore, this method has been described as 'speculation'; there is a risk that the covered interest parity relation, due to external economic events, etcetera, does not hold.
Lastly, it is also important that while this is a method commonly used in practice, it is ethically questionable; thus, one should sagaciously weigh the pros and cons of this method before implementation.
External FX risk-mitigation options/methods - forward contracts, futures, and options contracts
Forward Contracts for FX risk-mitigation
Firms can enter into a forward contract with the bank/broker to eliminate the risk of currency fluctuations and exposure to volatility in the FX markets. This is the most popular method of hedging financial risk as the company is able to fix in advance, the rate at which the transaction will take place in the future, as the risk is transferred to the bank.
For example, a Canadian company ordering hoverboards from a supplier in Germany may be due to pay them in 3 months; the acquiring party may be concerned about the currency risk in the transaction, and to eliminate the currency risk, the Canadian party may enter into a forward contract today with their principal bank/broker to buy the required currency, at a rate fixed today, in 3 months' time. The bank would quote them a fixed rate for the Euros they need to pay the German party in three months' time.
This would, essentially, eliminate all risk in the transaction; this is a simple method that is widely used and has low transaction cost; forward contracts can also be flexible and tailored to the need of the company.
Nevertheless, there is a secondary risk that we must understand; for example, if the transaction is delayed by the TP, because the company is a signatory to the forward contract with a bank, it would be contractually required to buy the foreign currency and deliver the local currency, as per the contract, on the date specified in the contract. This, of course, can create problems if the TP delays the transaction.
Another disadvantage is that there is no upside potential with a forward contract. The price is locked, and the contract terms must be met. Thus, if an in-depth quantitative and qualitative analysis suggests that the company's local currency is likely to appreciate against the currency of the TP, getting into such a contract—while a justifiable risk-averse approach—may not be advantageous for the firm.
Futures (futures contracts) for FX risk-mitigation
Firms can use the FX futures contracts traded on the futures exchange to hedge against currency risk; futures are standardized contracts for fixed amounts of money for a limited range of future dates. These contracts can easily be traded through FX brokerage accounts. Only whole number multiples of amounts can be bought & sold, so an exact matching of the amount to be hedged isn't possible.
To use this method, we leave the transaction to risk; for example, if we have to pay 1 million GBP in 3 months' time, we buy forward contracts of GBPUSD through our brokerage account to cover our position; if USD depreciates, and GBP appreciates, we will make a profit on our contracts. We would lose money due to USD (assumed home currency in this example) having depreciated, but we will have gained money on our GBPUSD long contract; the profit on the contracts will offset the losses caused by the depreciation of the dollar, and hence, the risk would be eliminated.
There is, nevertheless, a requirement of depositing a margin for executing the trade in the brokerage account. Furthermore, there may be a slight difference between spot and future quoted prices. It is also essential to understand that these contracts aren't tailored instruments, and an exact number of future contracts to hedge the amount may not be available, thus, mandating the use of contracts that match the amount to the closest degree.
Options for FX risk-mitigation
An option is the right to buy/sell an underlying at a fixed rate on a future date. The difference between an option and a forward contract is that options grant the holder the right to choose whether they would want to exercise the option or not. I.e., we have a choice, on the date of expiry (in case of European style options), to exercise or not to exercise our right(s). This choice is available throughout the life of the option when an option is an American-style option.
For hedging currency risk, this means that if a firm hedges currency fluctuation risk through options, if the exchange rate for a future transaction moves against the firm, the managers will have the right to exercise the option; however, if the exchange rate moves in the firm's favor, management won't have a contractual binding to exercise the option (i.e., no obligation).
For example, if we are due to pay our supplier C$1 million in 3 months' time, we can acquire an option from the bank/broker at a specific rate today, i.e., we would be entitled to buy C$1 million on the date in the option if it is a European style option & throughout the life of the option if it is an American style option.
If the exchange rate moves against us, i.e., if the US dollar (assumed home currency) depreciates, we'll have the option to buy the C$1 million from the broker/bank (option writer) at the exercise price of the option. If the exchange rate moves in our favor, i.e., the USD appreciates, we can convert at the spot rate at the date of the transaction, as we'll not be obliged to buy the C$1 million; thus, we wouldn't be exposed to downside risk, but we will have upside potential in the trade.
FX Options can easily be acquired through a brokerage account (exchange-traded options) & also over-the-counter (OTC) through financial institutions; thus, using options as a hedge isn't a convoluted process.
Nevertheless, we have to pay for the option, i.e., pay the option premium, whether or not we exercise it. Options are valued through models such as the Black-Scholes option valuation model, and during times of high volatility, they can be costly (premiums can be very high). This is especially true for long-duration options and options on FX pairs that are considered very volatile.
Firms can also use offsetting methods to hedge the currency risk; This can be done internally through an internal netting center for a large conglomerate; smaller or regional firms can also benefit from this method by joining an international Netting center.
How this method works:
There may be a company in Australia this is required to make a payment to the US (home) around the same date that a US firm is required to make a payment to a TP in Australia of the same approximate amount; the two businesses may be concerned about the currency risk and may want to eliminate it through hedging.
A netting center may bind the two payments, and the risk for both parties would be eliminated, the money the Australians have to pay in the US, and the money the US firm has to pay in Australia, being the same approximate date and amount, would offset each other. Having moved in this arrangement, say, three months before the payment date, both parties would have eliminated the FX risk to their organizations.
The netting center, usually an international bank, manages such transactions; this is an efficient and cost-effective method to eliminate the FX risk; nevertheless, there is a potential of conflict or problems such as a cancelation of payment of the other party involved (however, this is reduced by working with sizeable international netting centers). Moreover, smaller businesses may not find this method feasible.
Money Market FX Hedge (MMH)
Similar in nature to the forward contract, the money markets hedge can be used to eliminate the FX risk organizations may be exposed to through international trades. We could use the money markets to lend and borrow (at the same time) to achieve a similar result as a forward contract; in fact, banks use this method to offer forward contracts to their clients.
The basic idea of MMH is to create an asset and liability that mirror future liability. This method can be implemented in the following manner:
For an MMH, we borrow USD (home currency) today till the day there is a requirement to pay the supplier, for example, in three months. We'll convert USD to YEN (supplier's currency) today at the spot rate. Because we don't have to pay the supplier today, we'll deposit the YEN in an interest-paying account for three months.
We'll have to deposit enough YEN, that with interest, the sum grows to the amount we are required to pay the supplier; we can divide the amount required to be paid by the periodic interest it will earn to derive the amount of YEN that we will have to deposit (amount to be paid ÷ (interest rate)^(time)).
The amount will grow—with interest in three months' time—to the amount we're required to pay the supplier. To put this amount in deposit, we will have to convert this exact amount to YEN today at the rate in relation to the USD, i.e., sell USD today at the spot rate to buy the YEN. We'll have to borrow this amount in USD &, of course, we'll have to pay interest on the borrowed amount; in 3 months' time, we'll be owing the original borrowed amount, plus the interest accrued.
In 3 months' time, the YEN deposit would mature to the amount payable to the supplier; on the other hand, we'll be required to pay the matured loan on our USD borrowings, the loaned amount with interest. Thus, we can see, by utilizing this method, the two amounts would be fixed, rendering the exchange rate irrelevant & eliminating the risk.
Economic risks faced by Businesses
Firms face internal and external economic risks. These risks, examples, and possible solutions are included in this section:
International economic risks
Firms dependent on suppliers and buyers in other countries/regions are reciprocally impacted by the economic conditions in such regions; thus, economic fluctuations/adverse periods, in the regions/countries the organization trades with, can directly affect the performance/bottom line. This is a crucial risk vector that should be thoroughly examined because if the leading suppliers/buyers of the firm are adversely impacted by the broader economic conditions in their countries/regions, the company can be affected severely as well. If the supply of the critical components/main product(s) is affected/disrupted due to international economic conditions, i.e., supply of most important core component(s) in the firms' offerings/product line, the whole business model can be disrupted.
If the TPs economy tanks, the companies that trade with them will be impacted directly; secondly, the cluster of industries that rely on international supply—not located in the country experiencing economic distress—due to their dependence on international suppliers, would, correspondingly, suffer.
This can also mean that some of the companies and industries that the business model of the subject relies on can go bankrupt and cease operations due to external economic conditions. This also means that even if the primary supplier isn't impacted by international economic turbulence, but members in its supply chain are impacted, and cannot survive the adverse period, the primary supplier would be impacted negatively by the bankruptcies, etcetera, in support industries it relies on.
In turn, because of problems faced by suppliers-of-suppliers, the subject firm may be unable to get all the components/resources required for its products/services and may not be able to meet the market demand.
Therefore, understanding the broader ecosystem in which the supplier operates is also crucial for a more comprehensive understanding of the risks the company may be exposed to, indirectly.
To counter/mitigate this concern, businesses should, of course, work to find alternative suppliers that can provide the crucial components/products that are required, ideally, in multiple countries with a low correlation in terms of economic factors (such as GDP); i.e., the economy of supplier 1 should have a low correlation with the economy of supplier 2.
Alternatively, the possibility of a collaborative co-manufacturing project can also be examined if the resources and organizational will are present.
For example, the launch of a bespoke production line in collaboration with the manufacturer. Such a move would also benefit the subject through real options, i.e., the option to expand or abandon, etc. On the other hand, in the worst-case scenario, manufacturing, etcetera, may have to be shifted in-house if all other avenues are exhausted. Short-term solutions such as an in-house refurbishing unit where returned products, etc., are refurbished can be utilized till an external supplier can be identified.
Economic change can be positive as well as negative, and both can impact TPs and the firm, in turn. For example, if the economies of the countries/regions our TPs, especially suppliers, exports to, boom, the demand of the products of the firms' suppliers & suppliers' suppliers should increase. An increase in demand, assuming the factors of production at the manufacturing facilities of the supply chain remains constant, should, logically, lead to increases in prices throughout the supply chain; this can impact the firm directly as it would be required to pay more for the products/components that it acquires from suppliers.
Furthermore, an economic boom in the domestic economy & economies of its suppliers can also impact the supply of labor required for operations and expansion. I.e., due to an increase in demand for skilled and unskilled workers in their economy, suppliers will have to pay more for their staff; they will have to charge more, in turn, for their products to cover the increase in cost. This will again mean that they will increase prices, which will impact the acquirers directly.
This phenomenon, in recent years, has been observed in China and has impacted international firms that rely on Chinese manufacturers. As the economy in China experienced considerable economic expansion, the demand for labor, skilled & otherwise, increased considerably; this led to an increase in labor costs and, subsequently, an increase in the manufacturing costs in that country. This increase led many firms to move production to other countries, such as Vietnam, Cambodia, etcetera. However, long-term, a similar rise in prices should be expected in the current regions of elevated interest as well.
Another issue, especially important for publicly traded companies, is the stock price. If the market price of the firm's shares collapses due to a market crash, scandal, increase in interest rates, etc., a number of issues can arise for the firm. If the stock price crashes, it can impact the firm's financing, as equity is used to raise initial or secondary capital, acquire another company, fund new projects, etc.
Moreover, Banks and financial institutions interpret the stock price as a proxy for a company's performance; a rapid decline in the market value of equity can send negative signals to financial institutions and credit rating agencies; this can lead to an increase in the rate of interest charged by financial institutions, further exacerbating a concerning situation.
Persistent adverse performance of the stock price can also frustrate shareholders, leading to action that can result in changes in the top management team (TMT) through shareholder activism. If the structure of the TMT is changed rapidly, it can create an environment of instability and concern for middle-management as well as the TMT, creating a cascading effect that impacts the entire organization, inducing an everyman-for-himself mentality in all employees, which can also result in 'Machiavellian' behavior by some. Suffice to say that such changes may create further instability if not done sagaciously.
A rapid stock price collapse can also lead to reputational damage, which can change customer perceptions regarding the firm's offerings, resulting in a demand reduction. Such demand reductions can further lower revenues and profits, which lowers the stock price further, resulting in a vicious cycle.
Depressed stock prices can also make the company susceptible to a hostile takeover. Market capitalization lower than the market value of total assets can also open the possibility of an external entity acquiring the company for asset stripping, i.e., individually selling the assets of the business for profiteering. For a understanding fundamental risks that new projects/investments face, and mitigating approaches that can be implemented, see our detailed report.
Mitigating economic risks faced by companies
To counter risks of price increases or supply-related issues, firms should sign long-term contracts with suppliers. This will ensure that if there is an increase in prices/costs for the supplier(s), the importing business isn't impacted as the suppliers would be contractually obliged to sell us at a price set in the contract.
Nevertheless, this method has limitations; contract implementation can be difficult, especially in emerging economies. Thus, if a business, for example, has a contract with a manufacturing facility in Bangladesh, if the Bangladeshi producer does not honor the contract, practically, there would be little recourse left for the international partner. There is little contract protection in emerging economies, and this factor should be thoroughly understood.
On the other hand, this method would be suitable to implement in developed economies where the legal framework provides considerable contract protection. For example, if the primary manufacturer of a company is a trading partner in Germany, then a long-term contract should indeed provide significant protection.
Businesses can also explore the possibility of an agile-style integration with the supplier(s).
Local/market economic risks
Businesses that only operate in one country, of course, have a higher risk exposure than a business that operates in multiple international markets; therefore, smaller/regional companies have a high degree of sensitivity to the local/national economy than internationally diversified businesses.
Companies should understand the relationship of their sales, revenues, etc., with the regional economy they operate in if they are a smaller firm & a broader market weighed relationship with the international markets they operate in (for large entities).
This can be done through numerical and statistical methods such as linear regression.
If through linear regression, for example, it is established that the company's revenues have a high beta in relation to the regional GDP, i.e., a 1% change in the nominal GDP is likely to cause, say, a 15% change in the firm's sales (with a beta value of 5), a sensitive relationship would be recognized.
This would mean that if the economy goes into recession, the business, in our example, will be severely impacted. Thus, fluctuations in the economy would be of high importance for understanding the impact of local economic risk; we can use quantitative methods (as described above), in conjunction with qualitative methods, to determine the impact on the business and the individual cash flows of our business for further in-depth analysis.
Quantitatively, the beta of the business in relation to various economic factors of importance should be calculated (linear regression ) for understanding a variety of crucial relationships.
We can apply a regression analysis on sales, in relation to the GDP per quarter, revenue to quarterly GDP, etc., for gaining data-driven insights for better strategic and tactical maneuvering; a long-term analysis of these influences will help us determine the impact of the economy on the business overall.
This can be done for individual areas of operations as well to create a structured map of operational risks in different regions/areas/countries for international corporations, to evaluate how each region/country, or city we operate in, may be impacted by the overall economic performance of those specific areas.
We can then formulate strategic responses proactively for the base-case, worst-case, and best-case scenarios. In the base-case strategic scenario analysis, no adverse economic events may be projected to occur, and the business may go as projected; however, in the worst-case scenario, demand might plummet, and we may be required to pivot, i.e., formulate strategies, with dynamic agility, to remain a going concern.
For example, if demand plummets or economic indicators suggest that demand may plummet in coming periods, the firm would be required to make contingency plans; the regression analysis derived forecast regarding demand reduction in different areas/cities/regions would be instrumental here. Further deductive analysis may reveal the potential impact on revenues, etc.
In a potential worst-case scenario, the firm would have to make difficult strategic decisions with agility; it may have to cease operations in areas worst affected (areas where demand is expected to remain low for the next 6-12 months). Moreover, unpopular tactical decisions will also have to be implemented, i.e., reduction in the number of employees; for example, those handling operations in areas worst affected; such decisions, that can be classified as 'cost-reduction requirements,' would be difficult, however, decisions that must be taken for the overall health of the business.
Ex-ante, companies should evaluate the flexibility & agility in their business model, pivoting organizational culture and operations towards a focus on creative solutions to overcome the crisis. Agility and adaptability are crucial in a crisis & firms that have the inherent capacity to pivot their tactics & strategy would, of course, navigate uncertainty better than those that cannot do so.
In such adverse periods, when the environment is changing at an unprecedented pace, it may be helpful to implement agile approaches such as Scrum, iterative Agile methodologies, etc., for navigating the crisis. Having a fundamentally inflexible 'crisis management plan' may actually be counterproductive. Thus, an iteration-based approach, that readjusts based on stimuli & welcomes change, may yield better results than a predictive, reactive plan.
In economic downturns, governments usually implement Keynesian tactics and increase their fiscal spending to stimulate the economy. In the next economic downturn, it is highly likely that governments in the US, Canada, Australia, etc., would continue to use Keynesian methods, as done in recent recessions, and pump fiscal stimulus in projects in areas that may be related to the subject firm or others in the firms' ecosystem.
Firms that can capitalize on such emergent opportunities through an internal capacity to pivot with agility would do better than businesses that cannot do so. Thus, even in a crisis, opportunities may emerge, and whether the firm can capitalize on such opportunities may be a make or break factor for future success.
For example, an organization, say, in a vehicle rental business, may slightly modify (or start) the consultancy team of the business so they may offer consultancy to the state and local governments for their traffic and mobility projects; Firms that collect substantial data can creatively formulate a strategy to monetize that data, etc. I.e., use data sagaciously to derive insights that are valuable and can be marketed. Such a pivot may provide the needed revenues to keep the business afloat.
To mitigate the impacts of a crash in stock price, companies should anticipate periods of market/economic distress and recalibrate their financial strategy to navigate the stresses that a crash in the firm's stock price may cause. As discussed in the previous section, a crash in stock price can impact the company's financing, market perceptions & product demand.
The risk of an adverse financial impact can be mitigated through adequate liquidity and access to cash during periods of distress. This can be achieved through internal means such as retained earnings and a stable position in short-term liquid assets. Alternatively, a contingent financing deal can also be signed with a financial institution, etc., before a crisis period. This may be a bank overdraft facility with a fixed rate agreed before periods of distress or a contingent private placement of preference shares with a financial institution such as a pension fund. Creativity can be used here as there are many possibilities for raising capital in periods of stability for a future distress period, such as royalty deals, securitization, etc.
For managing reputational damage and a related drop in demand, businesses should continually focus on nurturing customer loyalty and trust; customer loyalty and confidence in the brand should insulate the company from external adverse events. Another method that can be implemented is to build confidence/loyalty in individual products/brands in a way that the products & brands that are carried aren't directly associated with the principal entity that owns & operates them.
This tactic would reduce the correlation between different products/brands that the parent entity carries and would protect the firm from a correlated reduction of demand across the board if the parent suffers reputational damage, an adverse period, etc.
For example, the 'Dove' personal care brand, owned and operated by Unilever, is arguably considered an independent brand line. Hence, it is insulated from adverse impacts that the parent entity, Unilever, may suffer, as most customers don't perceive it to be a direct offering from Unilever. It would have been a different story if the brand had been marketed as 'Dove by Unilever.' If that indeed was the case, then adverse impacts suffered by Unilever would have a much higher impact on perceptions regarding Dove as a brand in the eyes of its customers.
Thus, the development of brand loyalty, confidence, perception, independent of a broader association with the principal parent entity that owns and operates it, can insulate the brand(s), protecting the overall revenues of the parent in adverse periods.
Here it may be argued that the parent's brand association may be required to improve the standing of new brands/products in the early life-cycle period; thus, this tactic may be considered impractical. However, parent entities can present new products and brands as associated with the principal brand in the growth stage of the new offering and then reduce such connection gradually so the new offering, over time, can develop its individual standing.
For example, if Pepsi launches a new juice brand, it may associate it with the Pepsi brand in the introductory and growth stages of the new brand; however, as the new brand achieves critical mass, the Pepsi co-branding can be receded to insulate the new brand from the adverse period the parent, Pepsi, may experience. Implementation of this tactic, over time, would shield the new brand from idiosyncratic risks that Pepsi faces and vice versa.
For maintaining employee morale when the entity's stock price is falling (which sends negative signals through the firms regarding compensations based on stock options, etc.), The TMT should hold open dialogue, explaining the situation honestly and presenting positive messages, such as a forecast that the adverse period is likely to be transitory. The TMT should also work to build confidence regarding the firm's long-term prospects—mainly focusing on key (difficult to replace) personnel.
Nevertheless, when things get tough, some people would surely jump ships; no amount of persuasion or confidence-building can provide complete protection.
Risks of an economic boom Businesses aren't adversely impacted only by economic downturns; economic booms can also adversely affect organizations that aren't prepared for such conditions.
For example, in an economic uptrend, inventories may be sold rapidly, leaving firms in a sold-out state for an extended period; this issue is especially important for businesses reliant on external manufacturers/suppliers because, in periods of high demand, the supplier(s) may be unable to keep up.
Such situations create two main risks: (1) the firm may lose out on potential profits as it wouldn't have inventory to sell. (2) due to a lack of inventory, customers may be attracted to competitor/substitute products. Such a condition can create a considerable loss in a stable customer base, which can happen quickly; if this condition persists, the firm's brand value, reputation, and profitability can experience substantial—at times irrevocable—damage.
To prevent such a situation from arising, the sensitivity of the offered products/services to the overall economy must be calculated. This may not be a major task for an international conglomerate with teams of quantitative consultants and data mining systems; however, for mid-size to small players, it may be a difficult task.
In an economic uptrend, regression analysis can also be used to forecast how the demand of the offerings increases and how that impacts revenues. Strategically, adequate supply must be secured for periods of elevated demand.
There are practically two major requirements here: (1) to evaluate how the overall economy impacts demand. This can be estimated through regression analysis. For example, an enterprise may have a beta of 3 in relation to the quarterly real GDP. Thus, management would estimate that if the real GDP increases by, say, 5%, sales—most likely—would increase by about 15% (3×5).
(2) estimating periods of economic contraction and expansion. This means understanding the cyclical trends in the expansion & contraction of the overall economy. This cycle is better understood through the business cycle approach. At the beginning of a business cycle, the economy usually starts to expand; this expansion is peaked in the late stages of the business cycle, after which a contraction usually occurs.
Therefore, logically, we can expect demand to be high during the middle and late stages of the business cycle. The regression analysis would give us an estimate regarding the sensitivity of demand to the economy, and we can use external analysis regarding the business cycle, such as the National Bureau of Economic Research's 'Business Cycle Dating' reports to estimate the cycle stage and expected impact on demand.
As the peak of the cycle is approaching and during the peak, the risk of inventory shortage would be highest, and thus, utmost attention regarding inventory management during this time is required.
Supply management and excess required capacity must be determined during this time; methods such as linear regression in conjunction with qualitative factors, as explained in this work, can be utilized for such analysis.
This also means that enterprises need to ensure that they can acquire the required supply from the supplier(s) within the required time, i.e., acquiring the necessary supply as per the required lead-time.
In economic uptrends, companies that are expected to remain a going concern are likely to see a considerable increase in demand. This factor should be understood and quantitatively evaluated. If further planning/strategizing is necessary, for example, regarding the need to expand operations for meeting the growing demand in the future, then decisions must be made with adequate lead-time so the problems, as explained above, are not experienced.
There may also be a substantial increase in free cash flow(s) during such periods, and strategic decisions regarding dividend payments, or share repurchase, etc., may also have to be made. It may be unwise to sit on large amounts of cash; however, making hasty, imprudent decisions, that reflect the current reality, but don't reflect a long-term business cycle view, may be counterproductive.
There may also be a need to strengthen the investment center during such periods in larger firms to have a number of positive NPV projects under evaluation so that they can be presented to the board. Smaller companies/teams can continually scan opportunities, utilizing qualitative & quantitative methods to pick the best opportunities based on a long-term economic analysis, strategic examination, and dynamics of their environment.
Political risks faced by companies and mitigation steps to reduce them
Changes in political structures & the government may also impact the business; for example, if the government changes, the new government may not have a favorable view towards the firm's fundamental business/business model. Political trends, ESG concerns, etc., may not favor the enterprise and may push officials towards taking adverse actions/sanctions against the firm; or, in the worst-case scenario, an outright ban on the products/services of the firm may be implemented. Companies must formulate strategic responses to various possible scenarios to avoid being in a quagmire if a severe action, as described above, is taken by the authorities/politicians. The aforementioned risk, of course, would be more concerning/precarious for companies operating in one market and being dependent on one product. Such a predicament, in the presence of other vectors of concern, considerably expands the overall business risk; in scenario planning, therefore, managers must be cognizant of the worst-case scenario(s) and must brainstorm approaches of tactical maneuvering, etc. Short-term and long-term responses to such a situation must be devised in scenario analysis.
"Anything that can happen will happen" Edward Aloysius Murphy Jr.
To tackle such challenges in the short-term, businesses can strategize regarding modifying their distribution and delivery channels for alternative products; such a move, at the very least, would ensure the company remains a going concern, while steps are taken to rectify the situation in the long-run with approaches such as lobbying the government or approaching the courts, etc.
For example, let's suppose a new political government is elected in a country, and the new government passes legislation against cola products, banning them indefinitely. The short-term response that the affected firms should take is to utilize their existing delivery & distribution channels for an agile pivot, readjusting their offerings so they may remain a going concern in the short term while other measures are taken for long-term survivability.
Goodwill accumulated overtime should also be leveraged in such a condition to persuade channel members to carry replacement products till long-term readjustments can be achieved.
Businesses should also ensure that they aren't reliant on one product, or product category, or heavily dependent on one category/product. The reason is quite apparent: in a dynamic environment, due to a plethora of factors, such as consumer preference, technological leapfrogging, regulation, etc., the main product/category may suffer an acute collapse in demand. Such a condition may be challenging to recover from (see the creative destruction process for further clarity).
It is also important to understand that some managers and strategists may assume that the product mix offered by their organization is adequate enough, even when a specific category dominates sales; a collapse of demand in that category may render secondary categories financially inviable; hence, the assumption of strong diversification in such a scenario wouldn't be accurate.
Even if an enterprise has a well-diversified product mix, with sales not heavily dependent on a specific category, there may be an interconnected element between the categories, where a negative impact on this interconnected element may create an overall risk for all products offered.
For example, let's assume a severe security concern regarding Microsoft's Windows OS is uncovered, which collapses its demand for a considerable period. In such a scenario, other product categories, which may not be categorized as an OS, such as MS Office, virtual studio, etc., but as categories dependent/reliant on the Windows platform, may also suffer a similar fate as the Windows OS.
A further example: suppose the demand for Apple's iPhone products collapses; in such a scenario, some may assume that because Apple has a diverse product mix, it would survive the demand collapse in one category, as it has other stable and growing categories such as iTunes, peripherals, etc. However, if iPhones stop selling, other peripherals that are used in conjunction with—or are mainly reliant on—the iPhone would also suffer a considerable decline in demand.
If iPhones' demand plummets, logically, demand for Air Pods, Apple watch, Air Tag, iTunes, etc. (products services that depend on the iPhone), would also plummet. A similar scenario may manifest if consumer preferences regarding the overall Apple software and ecosystem change. Therefore, we can see that product mix diversification may seem solid on its face, but in actuality, a decline in one foundational category may effectively bankrupt the company.
In the long-term, companies should strive to enter international markets with their offerings, invest in maintaining/broadening their competitive and technological advantages, and should strive to restart the creative destruction process. Effective diversification of the product mix should also be a priority.
Such objectives can be achieved through internal, organic development, or through alliances/acquisitions, etc. Other methods such as a franchise model to lower the risk for international expansion can also be implemented, especially by those who don't have any experience in international expansion.
A continuous effort for developing new users and new uses for the offering should also be an area of interest.
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