Transaction Exposure: Definition, Example, Hedging Strategies

What Is Transaction Exposure?

Transaction exposure is the level of uncertainty businesses involved in international trade face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to major capital losses for these international businesses.

Transaction exposure is also known as translation exposure or translation risk.

Understanding Transaction Exposure

The danger of transaction exposure is typically one-sided. Only the business that completes a transaction in a foreign currency may feel the vulnerability. The entity that is receiving or paying a bill using its home currency is not subjected to the same risk.

Usually, the buyer agrees to buy the product using foreign money. If this is the case, the hazard comes if that foreign currency should appreciate, as this would result in the buyer needing to spend more than they had budgeted for the goods.

Combating Transaction Exposure

One way that firms can limit their exposure to changes in the exchange rate is to implement a hedging strategy. By purchasing currency swaps or hedging through futures contracts, a company is able to lock in a rate of currency exchange for a set period of time and minimize translation risk.

In addition, a company can request that clients pay for goods and services in the currency of the company's country of domicile. This way, the risk associated with local currency fluctuation is not borne by the company but instead by the client, who is responsible for making the currency exchange prior to conducting business with the company.

Example of Transaction Exposure

Suppose that a United States-based company is looking to purchase a product from a company in Germany. The American company agrees to negotiate the deal and pay for the goods using the German company's currency, the euro. Assume that when the U.S. firm begins the process of negotiation, the value of the euro/dollar exchange is a 1-to-1.5 ratio. This rate of exchange equates to one euro being equivalent to 1.50 U.S. dollars (USD).

Once the agreement is complete, the sale might not take place immediately. Meanwhile, the exchange rate may change before the sale is final. This risk of change is transaction exposure.

While it is possible that the values of the dollar and the euro may not change, it is also possible that the rates could become more or less favorable for the U.S. company, depending on factors affecting the currency marketplace. When it's time to conclude the sale and make the payment, the exchange rate ratio might have shifted to a more favorable 1-to-1.25 rate or a less favorable 1-to-2 rate.

Regardless of the change in the value of the dollar relative to the euro, the German company experiences no transaction exposure because the deal took place in its local currency. The German company is not affected if it costs the U.S. company more dollars to complete the transaction because the price, as dictated by the sales agreement, was set in euros.