Transaction exposure is the risk of loss from a change in exchange rates during the course of a business transaction. This exposure is derived from changes in foreign exchange rates between the dates when a transaction is booked and when it is settled. For example, a company in the United States may sell goods to a company in the United Kingdom, to be paid in pounds having a value at the booking date of $100,000. Later, when the customer pays the company, the exchange rate has changed, resulting in a payment in pounds that translates to a $95,000 sale. Thus, the foreign exchange rate change related to a transaction has created a $5,000 loss for the seller. Transaction exposure is only applicable to the party in a transaction that has to pay or receive funds in a different currency; the party only dealing in its home currency is not subject to translation exposure. This can be a significant risk when the currencies involved in an international transaction have a history of significant fluctuations.
The basic rules for transaction exposure are:
Importing goods. When a business is importing goods and its home currency weakens, the firm incurs a loss. If the home currency strengthens, it experiences a gain.
Exporting goods. When a business is exporting goods and its home currency weakens, the firms experiences a gain. If the home currency strengthens, it incurs a loss.
When an organization does not want to run the risk of incurring a loss related to transaction exposure, it can adopt a hedging strategy, where it enters into a forward rate agreement, thereby locking in the current exchange rate.