Navigating Exchange Rate Fluctuations: Understanding Transaction Risk

With a growing number of companies adopting multiple currencies, a deep understanding of the various types of FX risks has become essential. As most CFOs are well aware, exchange rate fluctuations can have profound implications for a company's financial stability. Among the many challenges posed by foreign exchange (FX) markets, transaction risk stands as a significant concern. 

Today, we'll investigate the role of transaction risk in FX risk management, and provide you with strategies to effectively mitigate it.

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Understanding transaction risk

Transaction risk, often referred to as currency risk, is the potential financial loss arising from unpredictable changes in exchange rates once a transaction takes place. From the moment a company makes a commitment - either a sale or a purchase - to its settlement, the movement in exchange rates might impact expected cash flows. This can lead to unexpected financial gains or losses.

Imagine this scenario: your company closes a deal with a foreign client, fixing a price in their local currency. But as it is common in B2B contracts, there’s a delay between the terms agreement and the settlement. As the payment date approaches, the exchange rate between your currency and theirs undergoes an unforeseen shift, causing the effective price of the deal to fluctuate. If not well mitigated, this transaction risk can either eat into your profits or inflate your expenses.

The greater the time gap between the initiation of a contract and its final settlement, the higher the transaction risk due to extended exposure to exchange rate fluctuations. 

As such, transaction risk poses a significant concern for CFO’s and treasury managers tasked with keeping income volatility under control. However, this is not the only risk demanding their attention. Let’s examine other important risks finance professionals need to be aware of, along with their differences from transaction risk.

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Distinguishing transaction risk from other FX risks:

Political instability, change in economic policy and geopolitical events are just a few examples of incidents that can impact a company's financial stability. But when crafting a successful FX risk strategy, it’s important to consider the following three.

• Economic risk, also known as operating exposure, arises from the broader implications of exchange rate fluctuations on a company's future cash flows and market value. 

Unlike transaction risk, which focuses on the immediate impact of exchange rate changes on payments and receipts, economic risk extends its influence over the long term. This risk becomes particularly relevant when a company conducts a substantial portion of its business in foreign markets or relies on global supply chains. 

• Translation risk, sometimes referred to as accounting exposure, centres around the impact of fluctuating exchange rates on the valuation of foreign assets, liabilities, and equity accounts when translated into the company's reporting currency.

Unlike transaction risk, which affects future cash flows, translation risk primarily affects financial statements and reporting. This can potentially influence investor perception and regulatory compliance.

• Pre-transaction risk: also called pricing risk, is when exchange rates might change between the time a company sets a price and when the deal is officially agreed upon.

Pricing exposure, in contrast to transaction exposure, emerges the moment a company establishes the price for a product or service. This exposure remains in effect until a transaction agreement is reached, either involving a purchase or sale.

Firms that harness the power of operating in multiple currencies often not only understand how to hedge the risks but also how to enhance their strategies by automating the process.

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Strategies to manage transaction risk

Companies can create multiple strategies to protect their revenues from fluctuations in exchange rates. Also known as hedging strategies, firms make use of financial derivatives to ensure the exchange rate will be the same now and at the time they have to execute a transaction. 

• A company can use a forward contract to fix the currency rate for a specific future date.

Let's consider a US-based Company LMN, which is anticipating a significant payment to their European supplier in three months, with the amount specified in euros. To mitigate the inherent transaction risk due to potential currency fluctuations, Company LMN adopts a forward contract strategy. Swiftly after settling the contractual terms, they enter into a forward contract with a financial institution. By doing so, they lock in the prevailing and desired exchange rate of 1 USD to 0.85 EUR, effectively shielding themselves from any market-driven variations in the exchange rate.

• An alternative approach to mitigate transaction risk involves the use of options. 

Take the case of company XYZ, an international exporter expecting payment in euros from an overseas client in six months. To safeguard against the potential depreciation of the euro, they employ options contracts. Given the present EUR/USD exchange rate of 1.15, Company XYZ invests in put options. These options grant them the privilege to exchange euros at 1.15, irrespective of subsequent rate changes. In the event of the euro weakening, these options empower them to lock in a favourable conversion rate, effectively preserving the anticipated payment's value and proactively minimising transaction risk.

Understanding transaction and other types of FX risks is crucial not only for designing a succesful currency management strategy to safeguard profit margins but also to ensure overall financial stability. This involves grasping the timing of transactions, the exposure to currency volatility and the importance of implementing hedging strategies to effectively mitigate these risks. 

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We Can Help

If you’re interested in learning more about transaction risk and how to mitigate it, then get in touch with our Currency Management Specialists. Discover how Kantox can help you with FX Hedging.