Transaction Risk Meaning Overview and FAQs
Transaction risk refers to the adverse effect of foreign exchange rate fluctuations on a completed transaction before settlement. It is the currency risk associated with the time delay between entering into a trade or contract and settling it.
Key Takeaways:
– Transaction risk is the chance that currency exchange rate fluctuations will change the value of a foreign transaction after completion but before settlement.
– It is a form of currency exchange risk.
– Transaction risk is greater with a longer interval between entering into a contract or trade and settling it.
– Derivatives like forwards and options contracts can hedge transaction risk by mitigating the impact of short-term exchange rate moves.
Understanding Transaction Risk:
Companies engaged in international commerce often have costs in a foreign country’s currency or need to repatriate profits back to their country. There is a time delay between agreeing on the terms of a foreign exchange transaction and completing the deal, creating a short-term exposure to currency risk. Transaction risk can lead to unpredictable profits and losses. Institutional investors and multinational corporations use derivatives to hedge this risk.
Example of Transaction Risk:
If a U.S. company repatriates profits from a sale in Germany, it needs to exchange Euros (EUR) for U.S. Dollars (USD). If the Euro depreciates versus the USD during the time between contracting and settlement, the company will receive fewer USD when the transaction is settled.
Hedging Transaction Risk:
Transaction risk creates difficulties for individuals and corporations dealing in different currencies, but hedging mechanisms can minimize potential loss. Forward contracts can lock in currency rates for a future date. Options allow companies to set an "at worst" rate and execute the transaction in the open market if the option expires out of the money. Near-term contracts are best for hedging this risk.
What Is Currency Risk?
Currency risk refers to the possibility of foreign currency exchange rate changes negatively impacting a business or investment. It applies to investments or projects denominated in or involving payments in foreign currency. Global corporations face currency risk as they operate domestically and overseas.
How Can a Company Minimize Foreign Transaction Risk?
Companies with overseas customers or international operations can engage in hedging strategies to mitigate transaction risk. For example, a company with 90-day payment terms could use 3-month FX options to lock in the current exchange rate.
How Is Transaction Risk Different from Translation Risk?
Transaction risk occurs when exchange rates change between making a transaction and settling payment in foreign currency. Translation risk is an accounting risk where the value of foreign assets or liabilities changes significantly on a company’s balance sheet over time.
