Transaction risk in foreign exchange (FX) refers to the possibility of experiencing financial losses or gains caused by changes in exchange rates that occur between the time a foreign currency transaction is agreed upon and when it is actually completed.
This risk exists because there is a time gap between entering into a foreign currency contract and the final payment or receipt of funds.
Important aspects of FX transaction risk include:
- It affects the cash flow of transactions conducted in foreign currencies.
- The risk arises from potential fluctuations in exchange rates during the period between agreement and settlement.
- Both foreign currency receivables and payables are subject to this risk.
- For example, if a company commits to pay an amount in a foreign currency but settles the payment later, any change in the exchange rate can result in paying more or less in the home currency.
- The duration between contracting and settling the transaction influences the degree of risk.
- To reduce exposure to transaction risk, companies often use financial instruments such as forwards or options to secure exchange rates.
In summary, transaction risk is the exposure to gains or losses caused by foreign exchange rate movements during the time lag between agreeing on a transaction and its settlement.