What Is Transaction Exposure?
Transaction exposure is the level of risk companies involved in international trade face, 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.
Risks of Transaction Exposure
The risk of transaction exposure is typically one-sided because only the company that pays or receives funds in a foreign currency may feel the exposure. The entity paying or receiving funds in its home currency is not subject to the same risk. Because the buyer generally agrees to purchase the item using the foreign currency, the concern is usually that the foreign currency's value will appreciate, requiring more funds in the buyer's currency to complete the transaction.
- The level of risk companies involved in international trade face.
- A high level of exposure to fluctuating exchange rates can lead to major losses for firms.
- The risk of transaction exposure is typically one-sided.
Real World Example of Transaction Exposure
Suppose that a United States-based company is looking to purchase a product from a company in Belgium. The U.S. company agrees to negotiate and pay for the product using 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 a 1-to-1.5 ratio. This means for every euro in product the U.S. company agrees to buy, it costs the U.S. company $1.50.
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 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-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 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.