Transaction Exposure

Published on :

21 Aug, 2024

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Transaction exposure is a type of foreign exchange risk faced by businesses operating in multiple countries. It arises from fluctuations in the exchange rate between two currencies in a foreign transaction, such as the sale or purchase of goods or services. One purpose of international business strategies is to minimize transaction exposure.

It is a company's risk due to changes in the foreign exchange rate of a currency used in its business transactions. In other words, it is the risk that a company's foreign currency transactions will lose value due to changes in exchange rates. This can change the value of a company's assets, liabilities, and future cash flows, causing potential financial losses.

What is transaction exposure?

Transaction exposure refers to the risk associated with changes in foreign exchange rates for foreign currency transactions.
Companies can manage transaction exposure by matching the currency of revenue and expenses, using hedging techniques, or diversifying operations and investments.
Hedging techniques such as forward contracts, options, and swaps can mitigate the risk of transaction exposure.
Understanding and managing transaction exposure is important for companies engaged in international business to protect against losses from fluctuations in foreign exchange rates.

Transaction Exposure Explained

Transaction exposure is a business risk. When a company engages in transactions with foreign counterparties, such as sales, purchases, or borrowings, it faces the risk that the value of the foreign currency received or paid will change due to fluctuations in the exchange rate. This risk is known as transaction exposure.

It occurs when a company has entered into a foreign currency transaction, such as exporting goods and receiving payment in a foreign currency or importing goods and paying in a foreign currency. In such cases, fluctuations in the exchange rate can result in changes in the value of the transaction.

For example, a US-based company that exports goods to Europe and receives payment in Euros is exposed to transaction exposure. If the value of the Euro decreases relative to the US Dollar, the company will receive fewer US Dollars for its exports, resulting in a loss. On the other hand, if the value of the Euro increases relative to the US Dollar, the company will receive more US Dollars for its exports, resulting in a gain.

Transaction exposure is a significant risk for companies engaged in international business, as fluctuations in exchange rates can significantly impact the value of foreign currency transactions. Therefore, companies must manage this risk to ensure that changes in exchange rates do not impact their business. Some strategies that companies can use to manage transaction exposure include hedging foreign currency transactions, diversifying their foreign currency exposure, and monitoring exchange rates regularly.

How To Manage?

There are several ways to manage transaction exposure, including:

Matching the currency of revenue and expenses: By aligning the currency of a company's revenues and expenses, it can reduce the impact of transaction exposure.
Hedging: Companies can use various hedging techniques, such as forward contracts, options, and swaps, to mitigate the risk of transaction exposure.
Diversification: By diversifying its operations and investments across multiple countries, a company can reduce the impact of transaction exposure.

Hedging Techniques

Hedging reduces the risk of exposure by entering into financial instruments that offset the losses from changes in exchange rates. Some common hedging techniques include:

Forward contracts

A forward contract is an agreement to buy or sell a currency at a predetermined rate for future delivery. Both parties in an agreement must accept the rate and time when it will be enforceable.

Options

An option is a financial instrument that gives the holder the right, but not the obligation, to buy or sell a currency. Both parties predetermine the exchange rate for such an arrangement.

Swaps

A swap is a financial instrument that allows two parties to exchange a series of payments in one currency for a series of payments in another currency.

Examples

Let us look at the following examples to understand the concept better.

Example #1

Consider that a company called Global Trading Inc. exports goods to Europe and receives payment in Euros. The company has a contract to export $1 million of goods to a European customer and expects to receive 1 million Euros in payment. When the contract was signed, the exchange rate was 1 Euro = 1.20 US Dollars.

However, several months later, the exchange rate has changed, and 1 Euro is now worth only 1.10 US Dollars. As a result, when Global Trading Inc. receives its 1 million Euros, it will only receive 1.1 million US Dollars. Whereas, it expected 1.2 million US Dollars. This loss of 100,000 US Dollars is an example of transaction exposure.

In this scenario, Global Trading Inc. was exposed to fluctuations in the exchange rate between the Dollar and the Euro. As a result, it suffered a loss due to the reduced value of the Euro relative to the US Dollar.

Example #2

Suppose a UK Manufacturing Ltd. imports raw materials from a supplier in Japan and pays in Japanese Yen. The company has a contract to purchase 100 million Yen worth of raw materials from its Japanese supplier. When the contract was signed, the exchange rate was 1 Japanese Yen = 0.0085 British Pounds.

However, several months later, the exchange rate changed, and 1 Japanese Yen is now worth 0.009 British Pounds. As a result, when UK Manufacturing Ltd. pays its 100 million Yen, it will have to pay 90,000 British Pounds instead of the 85,000 British Pounds it expected. This increase of 5,000 British Pounds is an example of transaction exposure.

In this scenario, UK Manufacturing Ltd. was exposed to fluctuations in the exchange rate between the British and Japanese currencies. As a result, it suffered a loss due to the increase in the value of the Japanese Yen relative to the British Pound.

Transaction Exposure Vs. Translation Exposure

Transaction exposure refers to the risk associated with changes in foreign exchange rates for foreign currency transactions. Whereas translation exposure refers to the risk associated with changes in the value of a company's financial statements due to exchange rate changes.

Transaction exposure concerns the impact of exchange rate fluctuations on a company's foreign currency transactions. In contrast, translation exposure concerns the impact of exchange rate fluctuations on the value of a company's financial statements.

Transaction Exposure Vs. Operating Exposure

Transaction exposure refers to the risk associated with changes in foreign exchange rates for foreign currency transactions. Operating exposure refers to the risk associated with changes in a company's competitiveness due to exchange rates.

Transaction exposure is the risk that a company's foreign currency transactions will lose value due to changes in exchange rates. Finally, operating exposure concerns the impact of exchange rate fluctuations on a company's long-term competitiveness.

Frequently Asked Questions (FAQs)

1. What is economic exposure and transaction exposure?

Economic and transaction exposure are both types of currency exposure faced by companies that engage in international business. Economic exposure refers to the long-term impact that changes in foreign exchange rates can have on a company's future cash flows, competitiveness, and profitability. Transaction exposure, on the other hand, refers to the short-term risk companies face due to changes in foreign exchange rates.

2. How to measure transaction exposure?

Transaction exposure can be measured by calculating the impact of changes in foreign exchange rates on the value of a company's foreign currency transactions. This can be done using the spot rate, the future rate, and the options-based method. Therefore, companies should regularly monitor their transaction exposure and take appropriate measures to manage this risk.

3. Is transaction exposure relevant?

Transaction exposure is relevant for companies engaged in international business, as it can significantly impact their financial results. Fluctuations in foreign exchange rates can result in changes to the value of a company's foreign currency transactions, which can impact its revenue, profitability, and cash flow. Transaction exposure can also impact a company's competitiveness, as changes in exchange rates can make its products more or less expensive relative to its competitors.