DEFINITION of Transfer Risk
Transfer risk is the threat that a local currency can't be converted into another nation's currency due to changes in nominal value or specific exchange restrictions. Transfer risk, also known as conversion risk, may arise when a currency is not widely traded and capital controls prevent an investor or business from freely moving currency in or out of a country.
BREAKING DOWN Transfer Risk
Transfer risk rose to the forefront in recent decades as businesses made international trade a large part of their normal operations. This increased the flow of goods and services across borders and helped keep prices low for a variety of goods. There are, however, risks involved in buying goods from a company on the other side of the world.
When a company in the United States buys goods from a company in Japan, the transaction is typically denominated in USD or Japanese Yen. These are frequently traded currencies, so it is relatively easy for the U.S.-based company to convert dollars into yen. Both countries also have well-regulated and stable economies that allow transactions to be conducted without any limitations. The choice of currency in an international transaction often depends on the needs and desires of each business.
In some cases, however, a business may purchase goods from a company located in a foreign country where it is more difficult to convert the currency. Companies are subject to the laws of the country where they do business. These laws may affect how business is conducted, bank transactions are processed, and goods are delivered.
For example, banking regulations in a country may prevent a business from withdrawing funds in a foreign bank after a sale for several months. While the funds are being held, the value of the foreign currency may decrease relative to the value of currency from the country the business is located in. This could result in the business losing money on the transaction.
Protecting Against Transfer Risk
Transfer risk puts businesses in risky situations but there are certain measures to limit the loss of capital. Some firms keep a reserve of cash, often known as allocated transfer risk reserve, to manage these challenges. It is an allowance a company keeps to protect against country risks and inconvertible currencies. The types of companies that maintain a transfer risk reserve can include large retail multinationals to big banks with exposure in various countries. A banking institution may establish an allocated transfer risk reserve for specified international assets when required by the Board, according to the Federal Deposit Insurance Corporation (FDIC).