Transaction exposure describes the risk and level of uncertainty that an investor, typically a business, takes on due to fluctuating international exchange rates. More specifically, there is a risk that currency exchange rates will change or fluctuate after a firm or investor has already taken on a specific financial obligation but the rate hasn’t locked in. This could change the total financial obligation on the exchange of currency. We cover how this works below but if you’re looking to invest internationally then you may want to consider working with a financial advisor to make sure you mitigate as much risk as possible.
What Is Transaction Exposure?
Transaction exposure is a concept that applies to international trade. When businesses or investors make a deal across borders, one of the most important issues is to determine which currency the deal will take place in. The company that uses foreign currency accepts what is known as “transaction exposure.”
Transaction exposure is the risk that currency fluctuations will change the value of a deal after it has been made. When a company agrees to make payments in a foreign currency, and that currency gains value, it gets more expensive for the company to make those payments. When a company agrees to receive payments in a foreign currency, and that currency loses value, the company will make less money off this deal.
This risk applies unilaterally, meaning that it applies only to the company operating in a foreign currency. The company operating in its own currency does not face risk from currency fluctuation because for them the underlying deal doesn’t change. They receive or issue the same payment, while the value of that payment changes for the company that needs foreign capital.
Transaction exposure should not be confused with translation exposure. Transaction exposure is the risk that currency fluctuations will change the value of the money in which a deal is conducted. Translation exposure is the risk that currency fluctuations will change the value of the underlying goods and services around which a deal is conducted. If the value of payments stays the same, but the goods or services that you’re paying for lose value, that’s translation exposure.
An Example of Transaction Exposure
Say that an American company, Import Co., makes a deal with a French company Export Inc. The U.S. company will buy cheese from the French company and import it to the United States. When they make the deal the euro trades to the dollar at a 1:1 exchange rate (accurate at the time of writing). The cheese costs 25 euros per pound. After the exchange rate, this comes to $25 U.S. per pound. Transaction exposure would apply as follows:
The Purchase Takes Place In Dollars
The companies can agree that this purchase will take place in dollars, meaning that their contract specifies that Import Co. will buy the cheese for $25 U.S. per pound. As a French company, Export Inc. will then convert those payments into euros once it receives them.
This creates transaction exposure for Export Inc. because they will receive payments in foreign currency. When the two companies make their deal, the exchange rate is 1 U.S.:1 Euro. Export Inc. can convert that $25 U.S. into 25 euros. But say the exchange rate shifts so that $1 U.S. is now worth 2 Euros. In that case, $25 U.S. converts into 12.50 euros and the deal has lost value for Export Inc.
As an American company dealing in its own currency, Import Co. faces no such risk. Their deal is worth $25 U.S. per pound no matter what happens to the exchange rates.
The Purchase Takes Place In Euros
The companies can agree that this purchase will take place in euros, meaning that their contract specifies that Import Co. will buy the cheese for 25 euros per pound. As an American company, Import Co. will have to convert its dollars into euros before each purchase.
This creates transaction exposure for Import Co. because it has to make payments in a foreign currency. When the two companies make their deal, the exchange rate is 1 U.S.: 1 Euro. Import Co. can get 25 euros for $25 U.S. before each purchase. But say the exchange rate shifts so that $2 U.S. is now worth 1 euro. In that case, it will cost Import Co. $50 U.S. to buy 25 euros, and the deal has lost value for them.
As a French company dealing in its own currency, Export Inc. faces no such risk. Their deal is worth 25 euros per pound no matter what happens to the exchange rates.
How Can You Manage Transaction Exposure?
The best way to manage transaction exposure is to deal in your own currency. This tends to be a difficult solution, however, because it’s zero-sum. When you’re dealing across borders at least one party must accept transaction exposure. In most cases, it is the buyer. Most sellers price their goods and services in their own currency, and foreign buyers must seek currency conversions.
The other common way to mitigate transaction exposure is through currency trades. By purchasing currency or forex futures contracts you can fix the price of money in advance. For example, a company that needs to make payments in a foreign currency can buy that currency or enter a futures contract for the currency. That will secure a supply of money for a known price, allowing them to mitigate some transaction exposure.
The Bottom Line
Transaction exposure is a term that applies to international trade. It is the risk that a deal will lose value when the currency in which someone makes or receives payments changes value after the financial obligation has been committed. This can change the overall value or cost of a transaction for investors but it’s a necessary risk in order to complete international transactions.
Tips for International Risk Management
- You don’t need to trade across borders to worry about risk and exposure. This can be an everyday occurrence if you’re investing without the right knowledge. This is where a financial advisor can help because they may be able to help you mitigate risk through proper management of your portfolio. Finding a financial advisor also doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Foreign currencies, or forex, are one of the most complicated and volatile parts of the market. It is fascinating, geopolitical and incredibly technical. You can learn more about how forex works and what it means for you.
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