What Is Transaction Risk?
Transaction risk refers to the adverse effect that foreign exchange rate fluctuations can have on a completed transaction prior to settlement. It is the exchange rate, or currency risk associated specifically with the time delay between entering into a trade or contract and then settling it.
- Transaction risk is the chance that currency exchange rate fluctuations will change the value of a foreign transaction after it has been completed but not yet settled.
- Transaction risk will be greater when there exists a longer interval from entering into a contract or trade and settling it.
- Transaction risk can be hedged through the use of derivatives like forwards and options contracts to mitigate the impact of short-term exchange rate moves.
Understanding Transaction Risk
Typically, companies that engage in international commerce incur costs in that foreign country's currency or have to, at some point, repatriate profits back to their country. When they have to engage in these activities, there is often a time delay between agreeing on the terms of the foreign exchange transaction and executing it to complete the deal. This lag creates a short-term exposure to currency risk, which arises from the potential change in price of one currency in relation to another. Transaction risk can thus lead to unpredictable profits and losses related to the open transaction. Many institutional investors, such as hedge funds and mutual funds, and multinational corporations use forex, futures, options contracts, or other derivatives to hedge this risk.
The longer the time differential between the initiation of a trade or contract and its settlement, the greater the transaction risk, because there is more time for the exchange rate to fluctuate. Transaction risk is inevitably beneficial to one party of the transaction but companies must be proactive to ensure that they protect the amount they expect to receive.
For example, if a U.S. company is repatriating profits from a sale in Germany. it will need to exchange the Euros (EUR) that it would have received for U.S. Dollars (USD). The company agrees to complete the transaction at a certain EUR/USD exchange rate. However, there is usually a time lag between when the transaction was contracted to when the execution or settlement happens. If in that time period, the Euro were to depreciate versus the USD, then the company would receive fewer U.S. Dollars when this transaction is settled.
If the EUR/USD rate at the time of transaction agreement was 1.20 then this means that 1 Euro can be exchanged for 1.20 USD. So, if the amount to be repatriated is 1,000 Euros then the company is expecting 1,200 USD. If the exchange rate falls to 1.00 at the time of settlement, then the company will only receive 1,000 USD. The transaction risk resulted in a loss of 200 USD.
Hedging Transaction Risk
Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period. However, there are strategies companies can use to minimize any potential loss. The potentially negative effect resulting from volatility can be reduced through many hedging mechanisms.
A company could take out a forward contract that locks in the currency rate for a set date in the future. Another popular and cheap hedging strategy is options. By purchasing an option a company can set an 'at-worst' rate for the transaction. Should the option expire out of the money then the company can execute the transaction in the open market at a more favorable rate. Because the period of time between trade and settlement is often relatively short, a near-term contract is best-suited to hedge this risk exposure.