What is 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.

Examples of Transaction Risk

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.

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Transaction Risk Example #2

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

If the EUR/GBP spot rateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more 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.

How to Manage Transactional 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 riskCredit RiskCredit risk is the probability of a loss owing to the borrower’s failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt’s principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more 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 riskA Country RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place.read more 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 ratingRisk RatingRisk rating assesses the risks involved in the daily activities and classifies them (low, medium, high risk) based on the impact on the business. It helps to look for control measures that would help cure or mitigate the effects of the risk and negate the risk altogether.read more,’ go a long way in determining a cap and exposure limits every market deserves, keeping in mind the companies policies.

How to Mitigate Transaction Risk?

Banks susceptible to transactional risk indulge in various hedging strategies through different money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more and capital market instruments, which mainly include currency swaps, currency futuresCurrency FuturesCurrency futures are contracts where two parties agree to exchange a specified quantity of a specific currency at a pre-agreed price on a specified date. They are traded over exchange and settled or reversed before the maturity date.read more, 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.

A company can also enter into a futures contract promising to buy/sell a particular currency as per the agreement; in fact, futuresFuturesFutures refer to derivative contracts or financial agreements between the two parties to buy or sell an asset in a particular quantity at a pre-specified price and date. The underlying asset in question could be a commodity (farm produce and minerals), a stock index, a currency pair, or an index fund.read more 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 riskDownside RiskDownside Risk is a statistical measure to calculate the loss in a security’s value due to variations in the market conditions. Also, it refers to the uncertainty level of realized returns being much lesser than the anticipated ones. read more 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;

  • 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.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.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.

Advantages of Transaction Risk Management

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-makersCountry risk and exposure policies for different markets at the same time supervise political instabilities.Regular backtesting on assets and liabilities denominated in foreign currenciesOrderly supervision of various economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more in different marketsSuitable internal controlInternal ControlInternal control in accounting refers to the process by which a company implements various rules, policies, or procedures to ensure the accuracy of accounting and finance information, safeguard the various assets of the business, promote accountability in the business, and prevent the occurrence of frauds in the company.read more and audit provisions

Conclusion

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 RiskWhat is Sovereign Risk?Credit Risks in BanksExchange Rate Risk