Definition of Transaction Risk
In international trade, the risk which arises because of the fluctuations in currency between the signing of contract and settlement of the contract, and the loss for a party because of this fluctuation is known as transaction risk or transaction exposure.
Whenever there is a transaction between the companies that involve cross-currency payments, the companies settle on an exchange rate at which the contract will be settled. There can be some time gap between the signing of the contract and the settlement date. In the time between signing and settlement, there can be fluctuation in these currencies. Because of that, one party suffers paying more or receiving less, which can reduce the value of the contract for that party.
Characteristics of Transaction Risk
A transaction risk occurs because of the currency fluctuations between the signing of the contract and the settlement of the contract. It can occur for a company due to the below reasons:
- Borrowing and lending if payment is made in foreign currency.
- Buying and selling goods or services in foreign currency and payment is made later.
- Acquiring a foreign company and payment is made in foreign currency
- Any transaction in which foreign currency payment is involved and payment is made in future
Examples of Transaction Risk
Following are the examples are given below:
Let’s suppose an Indian company has signed a contract with a US company to acquire some asset from the US company at the contract value of $1 Mn and promise to make the payment after 3 months. Currently, the exchange rate is $ 1 = INR 70. So at the current rate, the contract value in INR will be $ 1,000,000 multiplied by 70, which means INR 70,000,000.
Now, after 3 months, assume the exchange rate is changed to $1 = INR 73. But in US Dollar, the company has to pay $1 Mn, which will be translated into INR INR 73,000,000. That means Indian company has to spend INR 3 million more because of currency fluctuations.
A company in Europe has bought some goods from another company which is situated in the USA on credit.
Buying company has to pay in dollars after 2 months. Suppose in 3 months; Euro gets depreciated against the USD; then the company has to pay out more currency in Euros to settle the USD transaction, which is a transaction risk.
Managing and Mitigating Transaction Risk
Transaction risk can be managed or mitigated in the following ways:
- Future hedge: if a firm is going to pay something in foreign currency in the future, then it can purchase that currency futures for a similar period. If the foreign currency appreciates in the future, it will have to pay more money in foreign currency, but it will benefit from the currency futures.
- Forward Hedge: Same way the firm can negotiate a forward contract to buy or sell the foreign receivables or payables.
- Money market hedge: To hedge the payables, the firm can borrow local currency and convert the local currency into foreign currency until the contract’s settlement. In the same way, to hedge the receivables, the firm can borrow foreign currency and convert it to local currency until the contract’s settlement.
- Currency Option hedge: To hedge the payables, a firm can purchase currency call options. Same way, to hedge the receivables, the firm can purchase currency put options.
Common Transaction Risks
Below can be the common transaction risks:
- Foreign Exchange Risk: This risk occurs because of the cross-border transactions between the parties involves.
- Commodity risk: This risk occurs because of the fluctuations of commodity prices such as oil and gas prices, which affect the buying nation’s whole economy.
Some of the advantages are given below:
- If the currency fluctuates in a positive direction for the company, then it will be saving the cash flows for the firm.
- Similarly, if the global oil price comes down, it will help the economy of buying country.
Disadvantages of transaction risk occur if the currency moves in a negative direction for the company or country.
- If the currency fluctuates in a negative direction for the company, then the firm will have to pay more than expected.
- Similarly, if the global oil price goes up, it will increase the inflation of buying country and affect the country’s economy.
In short, transaction risk is the risk or exposure because of inter-currency transactions and the occurrence of losses because of the fluctuations in the foreign currency. This fluctuation will affect the cash flow of the firm or country.
This is a guide to Transaction Risk. Here we also discuss the definition and characteristics of transaction risk along with advantages and disadvantages. You may also have a look at the following articles to learn more –