Transaction exposure definition
/What is Transaction Exposure?
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. This is a particular concern when there is a lengthy gap between the start of a transaction and when payment is received.
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 noted below:
Transaction exposure when 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 on the transaction.
Transaction exposure when exporting goods. When a business is exporting goods and its home currency weakens, the firm experiences a gain. If the home currency strengthens, it incurs a loss on the transaction.
Example of Transaction Exposure
As an example of transaction exposure, a company in the United States sells 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 the transaction has created a $5,000 loss for the seller.
Hedging Strategy
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. There is a cost to doing so, since the organization will have to pay for the cost of this agreement.
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FAQs
How does Transaction Exposure Differ from Translation Exposure?
Transaction exposure arises from the risk of exchange rate fluctuations affecting the value of actual foreign currency transactions, such as payables or receivables. Translation exposure, on the other hand, involves the impact of currency changes on the reported financial statements of foreign subsidiaries when consolidated into the parent company’s currency. While transaction exposure affects cash flow and realized profits, translation exposure primarily impacts accounting values without immediate cash consequences.