Transaction risk definition
/What is Transaction Risk?
Transaction risk is the probability that a party to a business transaction will lose money due to an adverse change in the relevant foreign exchange rate. This is a particular concern for organizations that conduct significant amounts of business in other countries. The parties to such a transaction can use hedging techniques to reduce or eliminate transaction risk.
Example of Transaction Risk
As an example of transaction risk, a company in Europe agrees to pay in U.S. dollars for production equipment that is sold by a firm in the United States, with payment due in 30 days. If the exchange rate for Euros weakens during the intervening 30 days, the buyer will have to spend more Euros to buy the dollars it needs to pay the seller.
How Transaction Risk Changes
Transaction risk tends to increase when there is a long period of time between entering into a contract and settling it, since there is more time in which the relevant exchange rate can vary.
How to Reduce Transaction Risk
There are several ways to reduce transaction risk, which are as follows:
Hedging Strategies
Forward contracts. Lock in ab exchange rate for a future date to eliminate uncertainty.
Currency options. Purchase the right (but not the obligation) to exchange at a predetermined rate.
Futures contracts. Buy a standardized contract traded on an exchange to hedge against currency fluctuations.
Natural hedging. Match revenues and expenses in the same currency to offset exposure.
Diversification and Risk Sharing
Multi-currency accounts. Hold funds in multiple currencies to reduce your conversion needs.
Multi-currency pricing. Invoice customers in their local currency to avoid currency risk.
Operational Strategies
Netting. Offset receivables and payables in the same currency to reduce your foreign exchange transactions.
Leading and lagging. Adjust the timing of payments based on expected currency movements.
Local financing. Borrow in the same currency as expenses to avoid conversion risks.
Payment Strategies
Reduce transaction time. Minimize the time between invoice issuance and payment to reduce exposure.