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What is Transaction Exposure?

Transaction Exposure

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Transaction Exposure

Transaction exposure, also known as transaction risk, refers to the potential for changes in the value of outstanding financial obligations due to fluctuations in foreign exchange rates. It is concerned with the effect of exchange rate changes on transactions that involve foreign currency and have already been recognized in the financial statements but have not yet been settled by cash payment.

In essence, transaction exposure represents the potential gain or loss a firm might experience because of changes in exchange rates between the time a transaction is initiated and the time it’s settled.

Example of Transaction Exposure

Let’s delve deeper into the concept of transaction exposure with a comprehensive example:

Scenario: TechFusion’s Laptop Sale to Germany

TechFusion, an American tech company, signs a deal on January 1 to sell laptops to a German retailer for €5 million. The payment for the laptops is due in six months, on July 1. When the deal is inked, the exchange rate is $1.20 per euro, so TechFusion records a receivable of $6 million (€5 million x $1.20).

However, exchange rates are volatile and can change over time.

Exchange Rate Fluctuation:

  • Situation A – Rate Depreciates: By July 1, let’s imagine the euro depreciates against the dollar, and the new exchange rate is $1.10 per euro.
    • Expected receivable: $6 million
    • Actual amount received: €5 million x $1.10 = $5.5 million
    • Exchange Loss: $500,000
    TechFusion would record an exchange loss of $500,000, given they receive less in USD than initially recorded.
  • Situation B – Rate Appreciates: Alternatively, if the euro appreciates against the dollar to a rate of $1.30 per euro by July 1:
    • Expected receivable: $6 million
    • Actual amount received: €5 million x $1.30 = $6.5 million
    • Exchange Gain: $500,000
    In this case, TechFusion would benefit from an exchange gain of $500,000, as they receive more in USD than they originally accounted for.

Conclusion:

In this scenario, TechFusion has transaction exposure of $500,000 due to the potential for exchange rate fluctuations between January 1 and July 1. Depending on how the rates move, TechFusion could either gain or lose half a million dollars.

To manage this risk, TechFusion might consider using hedging instruments. For instance, they could enter a forward contract to lock in the exchange rate of $1.20 per euro for the future date. This way, regardless of how the currency fluctuates, TechFusion is guaranteed to receive $6 million on July 1, eliminating the transaction exposure.

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