Transaction exposure is the degree of uncertainty that businesses engaged in international trade are exposed to. It is primarily the chance that exchange rates for currencies can fluctuate following the time a business has completed an obligation to pay. Transaction exposure is also known as translation exposure or translation risk. The risk of exposure to transaction is usually only one-sided. Only those businesses that make an exchange using a foreign currency could be vulnerable. A company who is paying or receiving bills using its own currency is not liable to the same risk.Usually buyers agree to purchase the item using money from abroad. If this is the situation then the risk is the currency of the foreign country appreciates in value, which could cause the buyer to have to spend more money than they planned for to purchase the item.
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Combating Transaction Exposure
One strategy for firms to minimize their exposure to fluctuations in exchange rates is by implementing the hedging method. Through purchasing currency swaps or hedging using futures contracts, a business can secure an exchange rate for a specified duration and limit the translation risk.In further, a business may require that its clients pay for services and goods using the currencies of the business’s country of residence. So the risk of the fluctuation of local currencies is not the responsibility of the business but instead the customer, who is the one responsible for the exchange prior to doing business with the business.
Transaction Exposure Management
Companies that engage in cross-currency trades can safeguard against the risk of transactions through hedge. Through currency swaps, currency futures or using the combination of these methods, the business can shield itself from risk of transactions by buying foreign currency. Utilize any of these methods to establish what the price of the currency cross transaction prior to its settlement.
Types of Transaction Exposure
Below are the kinds of transactions where exposure is a result:
1. Selling and buying goods or services on a credit-based basis when the prices are listed as foreign dollars.
2. Lending and borrowing money, where repayment must be using foreign currencies.
3. As a contracting party to the contract in which there is a forward-contract in foreign exchange, and these contracts are not being performed or overperforming.
4. Buy assets or take on the liabilities that are in foreign currency.
5. Any other transaction that is subject to the potential for future performance and is financed of foreign currency.
Example of Transaction Exposure
Imagine that a U.S.-based firm is seeking to purchase the product of a company located in Germany. The American firm agrees to negotiate the purchase and to pay for the item by using one of the German company’s currency: the euro. Let’s suppose that, when it comes to the time that the U.S. firm begins the process of negotiations and the price of the dollar/euro exchange is an 1-to-1.5 ratio. This ratio of exchange is equivalent to one euro equal in 1.50 U.S. dollars (USD).Once the deal is signed however, the sale may not happen immediately. In the meantime the exchange rate might change prior to the sale becoming complete. The risk of this change is an exposure to the transaction.
It is possible that the value of the dollar as well as the euro will not change however, it is possible that the rates change and become more or less advantageous to those working for the U.S. company, depending on the factors that affect the exchange rate market. At the time of closing the sale and pay the payment then the ratio of exchange could have changed to an advantageous 1-to-1.25 rate or to a lower 1-to-2 rate.Regardless of any change regarding the worth of dollars compared to the euro in this case, the German company is not affected by the risk of transaction because the sale was conducted in its currency of choice. The German firm is not affected by the fact that it will cost its U.S. company more dollars for the transaction to be completed because the price, as stipulated by the sale agreement was stipulated in euros.
If a business imports products and its currency decreases, the company suffers losses. If the currency at home grows, the business will see an increase.
When a company exports products and its currency is weaker, the business receives a profit. If the home currency increases and the company loses money, it suffers.
If a company doesn’t wish to take on the possibility of sustaining an expense related to exposure to transactions and exposure, it could adopt an hedging strategy where it signs an agreement on forward rates which locks the exchange rate at the present.
Risks of Transaction Exposure
In the above example of two companies X and Y the Company X has the benefit of that faces the threat of exposure to transactions due to the fact that the conversion of $1000 in two instances provides two receipts with a different value.But for the company Y it would have no exposure since, in all cases it will have to pay $1000 just. There is no changes in that value.From this, it is possible to see that the risk is only to the entity that has payables or receipts which can be converted into their currency. Parties to whom the value of the contract remains fixed i.e. the value is in their own currency, do not take on the risk of risk of exposure to transactions risk.High exposure could lead to massive losses for the party.There are ways and methods to reduce and control the risk of foreign transactions, such as hedges, or joining into the same transaction volume , wherein cash flows offset either whole or in part the flow of cash that is causing transaction exposure.
In a nutshell, we can define transaction exposure as an economic risk that results from the possibility that gains or losses could be incurred due to transactions that have been completed and that are based on foreign currency that result in real gain or loss. It could result in changes in the cash flow of the company.