Transaction Risk

Transaction risk is a change in a foreign transaction settlement's cash flow due to an unfavorable exchange rate change. It generally increases with the increase in the contract period.

• Transaction risk involves changes in the cash flow of a foreign transaction settlement due to unfavorable exchange rate fluctuations. This risk tends to increase as the duration of the contract extends.
• These risks are often aligned with credit and market risks, centralizing the establishment and administration of a comprehensive risk management framework.
• Many banks have established secure procedures to address transactional risk. However, a crucial lesson from the Asian Crisis is the importance of maintaining a healthy balance between credit and liquidity to mitigate potential risks effectively.

Below are some examples of Transactional Risk.

Transaction Risk Example #1

For example, A British company is repatriating profits to the U.K. from its business in France. It will have to get Euro earned in France converted to British Pounds. The company agrees to enter into a spot transaction to achieve this. Generally, there is a time lag between the actual exchange transaction and settlement; as such, if the British pound appreciates as compared to Euro, this company will receive fewer pounds than what was agreed to.

Transaction Risk Example #2

Let's build a numerical example to solidify the concept of transaction risk.

If the EUR/GBP spot rate were 0.8599, where 1 Euro can be exchanged for 0.8599 GBP and the amount to be sent back is €100,000, the company would expect to receive GBP 85,990. However, if the GBP appreciates at the time of settlement, it will require more Euro to compensate for one GBP; for example, let’s say the rate becomes 0.8368, and the company will now receive only GBP 83,680. That’s a loss of GBP 2,310 due to transaction risk.

A lot of it can be understood from the practices of central banks, especially investment banks, who are heavily involved in multiple currency dealings daily. These banks have formal programs in place to combat transactional risk.

These risks are usually synced with credit risk and market risk, which are centralized to institute and administer command over the entire structure of risk operations. There may not be a consensus in terms of who in the organization assumes the job of determining transactional risk; however, most commonly, a country risk committee or credit department does the task.

Banks typically assign a country rating that encompasses all types of risk, including currency lending, locally and abroad. Important to note is that these ratings, especially 'transactional risk rating,' go a long way in determining a cap and exposure limits every market deserves, keeping in mind the companies policies.

Banks susceptible to transactional risk indulge in various hedging strategies through different money market and capital market instruments, which mainly include currency swaps, currency futures, options, etc. Each hedging strategy has its own merits and demerits, and firms make choices from a plethora of available instruments to cover their forex risk that best suits their purpose.

By buying a forward contract, let's try understanding a firm's risk mitigation attempt. A firm may enter into a currency-forward deal where it locks the rate for the contract period and gets it settled at the same rate. By doing this firm is almost certain of the quantum of the cash flow. This helps encounter the risk of rate fluctuations and brings more excellent decision-making stability.

A company can also enter into a futures contract promising to buy/sell a particular currency as per the agreement; in fact, futures are more credible and highly regulated by the exchange, eliminating the possibility of default. Options hedging is also a perfect way of covering rate risks, as it demands only a little upfront margin and curtails the downside risk to a great extent.

The best part about the options contract and the main reason they are preferred is that they have unlimited upside potential. Additional, they are a mere right, not an obligation, unlike all the others.

A few operational ways through which banks attempt to mitigate Transaction risk;

1. Currency invoicing involves billing the transaction in the currency that is in the company's favor. This may not eradicate exchange risk; however, it shifts the liability to the other party. A simple example is an importer invoicing its imports in the home currency, which shifts the fluctuation risk onto the shoulder of the exporter.
2. A firm may also use leading and lagging in hedging the rate risk. Let’s say a firm is liable to pay an amount in 1 month and is also set to receive an amount (probably similar) from another source. The firm may adjust both dates to coincide. They are thereby avoiding the risk altogether.
3. Risk sharing: The parties in the trade can agree to share the exposure risk through Mutual understanding. A company can also avoid assuming any exposure by dealing only and only in home currency.

An efficient transaction risk management aids in creating an atmosphere beneficial for effective overall risk management operation in an organization. A sound transaction risk mitigation program includes and thereby promotes,

• A comprehensive inspection by decision-makers
• Country risk and exposure policies for different markets at the same time supervise political instabilities.
• Regular backtesting on assets and liabilities denominated in foreign currencies
• Orderly supervision of various economic factors in different markets
• Suitable internal control and audit provisions

Every company expecting a cash flow in a transaction subject to uncertain fluctuation faces a transaction risk. Many banks have in place a secured mechanism to address transactional risk. However, one of the best lessons learned from the Asian Crisis is the consequences of failure to keep a good balance between credit and liquidity.

It is essential for companies exposed to forex to draw a reasonable tolerance level and demarcate what extreme exposure for the company is. Spell out the policies and procedures and implement them precariously.

This has been a guide to Transaction Risk and its definition. Here we discuss how to manage and mitigate transaction risks, examples, and explanations. You can learn more about financing from the following articles –

• Political Risk
• What is Sovereign Risk?
• Credit Risks in Banks
• Exchange Rate Risk