Navigating Exchange Rate Fluctuations: Understanding Transaction Risk
12 September 2023 · 3 min read
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, fluctuating exchange rates 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 mitigate it effectively.
Transaction risk, often referred to as currency risk, is the potential financial loss arising from changes in exchange rates between the moment a transaction is agreed and the moment it is settled. From the moment a company makes a commitment – either a sale or a purchase – to its settlement, the movement in exchange rates is bound to impact expected cash flows.
Imagine this scenario: your company closes a deal with a foreign client, fixing a price in their local currency. As the settlement date approaches, the exchange rate will have shifted, thereby affecting profit margins. If not well mitigated, this transaction risk can either eat into your profits or inflate your expenses.
Transaction risk overlaps with both cash flow and accounting measures, depending on the timeline of the transaction. For the cash flow element, the relevant time lapse occurs between the moment of the sales agreement and the settlement.
For the accounting exposure, the relevant time lapse happens between the moment the invoice is recognised and the settlement. Whatever the case, one thing is sure: the greater the time gap between the initiation of a contract and its final settlement, the higher the transaction risk.
Political instability, changes in economic policy and geopolitical events are just a few examples of incidents that can affect a company’s financial stability through the impact on FX markets. 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. It comprises operating risk —the extent to which currency fluctuations can alter a company’s future operating cash flows— and the cash flow element of the transaction risk.
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.
Pricing risk, in contrast to transaction exposure, emerges the moment a company establishes the price for a product or service with an FX rate. 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.
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, Company LMN sells a forward contract. By doing so, they lock in the prevailing and desired exchange rate of 1 USD to 0.85 EUR, effectively shielding themselves from fluctuations 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 buys a put option. The option grants them the right, but not the obligation, to exchange euros at 1.15, irrespective of subsequent rate changes.
- In the event of the euro weakening, the contract empowers them to lock in a favourable conversion rate, effectively preserving the anticipated payment’s value and proactively minimising transaction risk. The downside of buying options is, of course, that a premium must be paid to the option seller in exchange for the privilege of deciding whether or not to exercise the option.
Removing FX Gains & Losses: Balance Sheet Hedging Redefined
In the context of a firm’s transaction exposure, currency managers that use forward contracts apply one of the two following approaches to managing transaction risk. Both are ineffective:
(1) Hedging at set dates or time-based approach. It consists in pulling, out of the ERP, the transaction exposure that is accumulated during an arbitrarily determined time-lapse —for example, once every month— and then executing the hedge. The process is repeated month after month.
Main pitfall: There is still a time lapse between the capture of the exposure and this ‘risk mitigation’ exercise. The goal of effectively protecting cash flows is not achieved.
(2) Basic micro-hedging. It consists in capturing every single piece of exposure and taking the corresponding FX hedge, thus minimising transaction risk.
Main pitfalls: (a) It is a resource-intensive activity, as companies might have thousands of transactions every day, which may lead management to restrict the number of currencies used; (b) It is not an effective strategy in the event of unfavourable forward points.
There is a middle ground between the two extreme approaches outlined here. It consists of a market-driven approach to FX hedging. Its key elements are:
- Accumulating exposure items. Instead of hedging right away, individual pieces of exposure or entries are aggregated to one another, creating larger positions.
- Conditional orders. Instead of hedging on a time-based, which is not a data-driven approach, we create conditional orders. Those orders are set with a dynamic stop loss and take-profit reflecting the firm’s risk tolerance and are automatically calculated from the weighted-average FX rate of positions.
If currency markets trade within a range that reflects managers’ tolerance, these conditional orders can effectively delay the execution of hedges, while still achieving the firm’s primary objective of protecting profit margins or removing FX gains and losses.
The execution of a hedge happens once the rate reaches either the upper take profit ceiling or the stop loss limit, protecting the accumulated amount. This brings the following advantages:
- Netting opportunities. Delayed hedge execution creates the possibility of taking advantage of netting opportunities, a natural way of removing costs.
- Forward points optimisation. In the event of unfavourable forward points (see below), savings on the carry can be achieved.
Understanding transaction risk and other types of FX risks is crucial not only for designing a successful currency management strategy to safeguard profit margins but also for ensuring 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.
If you are a CFO in a company navigating the global business landscape, make sure to stay tuned to how technology is reshaping this field through automation.
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.