What risks are incurred in making loans to borrowers based in foreign countries? Explain.
Two risks involved in making loans to borrowers based in foreign countries are foreign exchange risk and sovereign risk.
Foreign exchange risk is the risk that one currency will fall or rise against another. This includes erosion (inflation); the value of the funds lent to a borrower becomes worth less, which can also be called Purchasing Power Parity (Saunders & Cornett, 2008). Foreign exchange risk also includes Interest Rate Parity risk, which means “the hedged dollar return on foreign investments just equals the return on domestic investments” (Saunders & Cornett, 2008, p. 445).
Sovereign risk is the risk that a foreign government may delay, or not allow a domestic company to pay their debts. When a countries economy weakens, a government can announce a debt moratoria, which is a delay in repaying interest and/or principle on debt” (Saunders & Cornett, 2008, p. 451). A government can also repudiate debt, which is an outright cancellation of all of a borrower’s current and future debt (Saunders & Cornett, 2008).
Saunders, A. & Cornett, M. (2008). Financial Institutions Management: A Risk Management
Approach. 7th Edition. McGraw-Hill-Irwin.