What is 'Transaction Exposure'?

Transaction exposure is the level of risk faced by companies involved in international trade, specifically, the risk that currency exchange rates will change after a company has already entered into financial obligations. A high level of exposure to fluctuating exchange rates can lead to major losses for firms.

Often, when a company identifies exposure to changing exchange rates, it will choose 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 typically one-sided because it is only felt by the company that instigates the deal and arranges to send funds in a foreign currency. The entity receiving the funds is not subject to the same risk. The concern is usually 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, and 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 that every euro the U.S. company agrees to pay costs the U.S. company $1.50 to acquire the product from the Belgian company.

Once the agreement is complete, the sale might not take place immediately. Meanwhile, 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 that 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 because the deal was initiated in its local currency. The Belgian company is not affected if it costs the U.S. company more dollars to complete the transaction because the price was set as an amount in euros as dictated by the sales agreement.

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