Transaction exposure, defined as a type of foreign exchange risk faced by companies that engage in international trade, exists in any worldwide market. It is the risk that exchange rate fluctuations will change the value of a contract before it is settled. This can also called transaction risk.
The risk that foreign exchange rate changes will adversely affect a cross-currency transaction before it is settled, can occur in either developed or developing nations. A cross-currency transaction is one that involves multiple currencies. A business contract may extend over a period of months. Foreign exchange rates can fluctuate instantaneously. Once a cross-currency contract has been agreed upon, for a specific quantity of goods and a specific amount of money, subsequent fluctuations in exchange rates can change the value of that contract.
A company that has agreed to but not yet settled a cross-currency contract that has transaction exposure. The greater the time between the agreement and the settlement of the contract, the greater the risk associated with exchange rate fluctuations.
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A company engaging in cross-currency transactions can protect against transaction exposure by hedging. By using currency swaps, by using currency futures, or by using a combination of these hedging techniques, the company can protect against the transaction risk by purchasing foreign currency. Use any one of these techniques to fix the value of the cross-currency contract in advance of its settlement.
For example, a domestic company signs a contract with a foreign company. The contract states that the domestic company will ship 1,000 units of product to the foreign company and the foreign company will pay for the goods in 3 months with 100 units of foreign currency. Assume the current exchange rate is: 1 unit of domestic currency equals 1 unit of foreign currency. The money the foreign company will pay the domestic company is equal to 100 units of domestic currency.
The domestic company, the one that is going to receive payment in a foreign currency, now has transaction exposure. The value of the contract is exposed to the risk of exchange rate fluctuations.
The next day the exchange rate changes and then remains constant at the new exchange rate for 3 months. Now one unit of domestic currency is worth 2 units of foreign currency. The foreign currency has devalued against the domestic currency. Now the value of the 100 units of foreign currency that the foreign company will pay the domestic company has changed – the payment is now only worth 50 units of domestic currency.
The contract still stands at 100 units of foreign currency, because the contract specified payment in the foreign currency. However, the domestic firm suffered a 50% loss in value.
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