Transaction risk definition
/What is Transaction Risk?
Transaction risk is the probability that a party to a business transaction will lose money due to an adverse change in the relevant foreign exchange rate. This is a particular concern for organizations that conduct significant amounts of business in other countries. The parties to such a transaction can use hedging techniques to reduce or eliminate transaction risk.
Example of Transaction Risk
For example, a company in Europe agrees to pay in U.S. dollars for production equipment that is sold by a firm in the United States, with payment due in 30 days. If the exchange rate for Euros weakens during the intervening 30 days, the buyer will have to spend more Euros to buy the dollars it needs to pay the seller.
How Transaction Risk Changes
Transaction risk tends to increase when there is a long period of time between entering into a contract and settling it, since there is more time in which the relevant exchange rate can vary.
How to Reduce Transaction Risk
There are several ways to reduce transaction risk, which are as follows:
Only conduct transactions denominated in your own currency. This shifts transaction risk to the party on the other side of the transaction.
Set up offsetting transactions, so that each purchase of a foreign currency is roughly offset by a sale of that currency for another transaction at about the same time.
Net your exposures with the transactions of other subsidiaries within your company.
Purchase offsetting hedges.