What is 'Transaction Exposure'
Transaction exposure is the risk, faced by companies involved in international trade, that currency exchange rates will change after the companies have already entered into financial obligations. Such exposure to fluctuating exchange rates can lead to major losses for firms.
Often, when a company identifies such exposure to changing exchange rates, it chooses to implement a hedging strategy, using forward rates to lock in an exchange rate and eliminate the exposure to the risk.
BREAKING DOWN 'Transaction Exposure'The risk of transaction exposure is generally one-sided, as it is only felt by the company creating a deal, arranging to send funds in a foreign currency, and not by the entity receiving the funds. Most commonly, the concern is that the value of the foreign company appreciates, requiring more funds in the buyer's local currency to complete the transaction.
Example of Transaction Exposure
Suppose that a company that is based in the United States is looking to purchase a product from a company in Belgium. The deal would be coordinated based on the local currency of the business that is receiving payment. In this case, the Belgian company is receiving the funds, so the transaction would be negotiated based on the Belgian company's local currency – the euro. As the U.S. company begins the process of negotiation, the value of the euro to the dollar could be 1:1.5. This means every euro the U.S. company agrees to pay costs it $1.50 to acquire the product from the Belgian company.
Once the agreement is complete, the sale might not take place immediately. This could mean that the ratio of dollars to euros may change before the sale is final. This risk of change is the transaction exposure. While it is possible that the values of the dollar and the euro may not change, it is also possible the rates could become more or less favorable for the U.S. company depending on factors affecting the currency marketplace. This could result in changes to the exchange rate ratio, such as a more favorable 1:1.25 rate or a less favorable 1:2 rate.
Regardless of the change in value of the dollar to the euro, the Belgian company experiences no transaction exposure, as the deal was made in its local currency. The Belgian company is not affected if it costs the U.S. company more dollars to complete the transaction, as the price is a set amount of euros as dictated by the sales agreement.