What Is Transaction Exposure?
Transaction exposure (or translation exposure) is the level of uncertainty businesses involved in international trade face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to major capital losses for these international businesses.
One way that firms can limit their exposure to changes in the exchange rate is to implement a hedging strategy. Through hedging using forward rates, they may lock in a favorable rate of currency exchange and avoid exposure to risk.
Hedging strategies may include currency swaps or currency futures.
Risks of Transaction Exposure
The danger of transaction exposure is typically one-sided. Only the business that completes a transaction in a foreign currency may feel the vulnerability. The entity that is receiving or paying a bill using its home currency is not subjected to the same risk. Usually, the buyer agrees to buy the product using foreign money. If this is the case, the hazard comes it that foreign currency should appreciate, costing the buyer to spend more than they had budgeted for the goods.
The risk for exchange rate fluctuations increases if more time passes between the agreement and the contract settlement.
- Transaction exposure is the level of risk faced by companies involved in international trade.
- A high level of exposure to fluctuating exchange rates can lead to major losses.
- The risk of transaction exposure is typically one-sided, meaning only the business that completes a transaction in a foreign currency feels the vulnerability.
Real World Example of Transaction Exposure
Suppose that a United States-based company is looking to purchase a product from a company in Germany. The American company agrees to negotiate the deal and pay for the goods using the German company's currency, the euro. Assume that when the U.S. firm begins the process of negotiation, the value of the euro/dollar exchange is a 1-to-1.5 ratio. This rate of exchange equates to one euro being equivalent to 1.50 U.S. dollars (USD).
Once the agreement is complete, the sale might not take place immediately. Meanwhile, the exchange rate may change before the sale is final. This risk of change is 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. More or less favorable rates could result in changes to the exchange rate ratio, such as a more favorable 1-to-1.25 rate or a less favorable 1-to-2 rate.
Regardless of the change in the value of the dollar relative to the euro, the Belgian company experiences no transaction exposure because the deal took place 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.