What is Transaction Risk
Transaction risk is the exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the higher the transaction risk, because there is more time for the two exchange rates to fluctuate.
Despite the lag between agreement and execution, there are strategies companies can use to minimize any potential loss.
BREAKING DOWN Transaction Risk
When companies repatriate profits or pay for goods overseas their is a time delay in agreeing on the purchase and executing the foreign exchange transaction to complete the deal. For example, if a U.S. company is repatriating profits from a sale in the U.K. it will need to shift British pounds to U.S. dollars. However, there is time between the decision and the execution and settlement of the deal, this period is known as transaction risk. In this instance, the risk lies in the GBP/USD cross rate.
Should the currency pair fall the company has been adversely affected by transaction risk because it will be receiving less U.S. dollars from the sale as the value of the GBP falls.
Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period. This volatility can be reduced through many hedging mechanisms. A company could take out a forward contract that locks the currency rate in 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. (Further reading: Investopedia Options Tutorial)