Transaction Risk
Transaction risk is short-term risk rises due to particular transaction.
It is the risk that foreign exchange rate will adversely affect organizational profitability.
It arises due to following conditions being met, if any these conditions do not exist, then there will no transaction risk:
- Receipt and payment in foreign currency rather than home currency.
- Payment and receipt (settlement) date against purchase and sale is different from agreement date of goods or services.
Increase in foreign exchange rate makes foreign purchases more costly. Movement in foreign exchange rates makes cost of purchases higher and lower. Cost of purchase for goods cannot be exactly known in home currency until settlement is made. It is due to timing difference between agreement date and settlement date. However, purchased goods are already being sold into market between those dates. If exchange rate moves adversely, then organization can do nothing to cover increased cost of purchase.
Similarly, increase in foreign exchange rate makes foreign sales less profitable. Period between which goods are sold and receipt is expected, foreign exchange movement can decrease the amount of money received in home currency.
Significant foreign exchange losses can create liquidity problem and in extreme cases end up in liquidation.
Fortunately, transaction risk can be controlled using appropriate Hedging techniques.
