Transaction Risk

Transaction Risk refer to the risk when the cash flow of one currency must be exchanged for another at a future date to settle a transaction.

What is Transaction Risk?

Whenever there is an involvement of foreign exchange, there is always a risk of currency conversion involved. Hence, we refer to Transaction Risk as the risk when the cash flow of one currency must be exchanged for another at a future date to settle a specific transaction. It can occur within a receivable or a payable context for a firm.

Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.

Examples of Transaction Risk:

Let’s take an example of an importer who has to pay the foreign currency in exchange for goods or services at a future date. The importer has a risk if that currency appreciates. For example, a U.K. company must pay CAD 100 million in six months. The spot exchange rate is GBPCAD 1.7165, and the six-month forward exchange rate is GBPCAD 1.7350. The cost of buying the CAD forward is higher than in the spot market, but the spot market is not relevant because the CAD is not yet needed. The forward market does allow the U.K.-based company to lock in the GBP cost of the transaction at 1.7350.

Another example – a Canadian company with operations in China is looking to transfer CNY600 in earnings to its Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6 CNY, and the rate subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100 (CNY600/6) would instead of CAD86 (CNY600/7). 

How Is Transaction Risk Different from Translation Risk?

Both transaction risk and translation risk are foreign currency risk exposures that some companies face. Transaction risk occurs when there is a change in exchange rates during the period when a transaction is made and when its payment terms are finally settled in foreign currency. Translation risk, on the other hand, is an accounting risk whereby the value of certain foreign assets or liabilities changes significantly on a company’s balance sheet from period to period.

Hedging Transaction Risk

Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period. However, there are strategies companies can use to minimize any potential loss. The potentially negative effect resulting from volatility can be reduced through many hedging mechanisms.

A company could take out a forward contract that locks in the currency rate for a set date in the future. Another popular and cheap hedging strategy is options. By purchasing an option a company can set an “at worst” rate for the transaction. Should the option expire out of the money then the company can execute the transaction in the open market at a more favorable rate. Because the period of time between trade and settlement is often relatively short, a near-term contract is best-suited to hedge this risk exposure. 

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.

Role of Forward Contracts and Other Hedging Methods

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;

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-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.