The transaction exposure component of the foreign exchange rates is also referred to as a short-term economic exposure. This relates to the risk attached to specific contracts in which the company has already entered that result in foreign exchange exposures. A company may have a transaction exposure if it is either on the buy side or sell side of a business transaction. Any transaction that leads to an inflow or outflow of a foreign currency results in a transaction exposure. For example, Company A located in the United States has a contract for purchasing raw material from Company B located in the United Kingdom for the next two years at a product price fixed today. In this case, Company A is the foreign exchange payer and is exposed to a transaction risk from movements in the pound rate relative to dollar. If the pound sterling depreciates, Company A has to make a smaller payment in dollar terms, but if the pound appreciates, Company A has to pay a larger amount in dollar terms leading to foreign currency exposure. In real world, a single transaction (sales and receipt) may take some period of time. For example, you sold goods to a foreign customer on 15 December 2005, and customer promised payment after two months. Now during these two months the exchange rate may fluctuate on either side and this will result in exchange gain or loss. These transactions may include import or export of goods on credit terms, borrowing or investing in foreign currency, receipt of dividend from foreign subsidiary. This type of exposure can be safe guarded by using hedging instruments. Reduce transaction exposure :
The risk that changes in exchange rates during the time it takes to settle a cross-border contract will adversely affect the profit of a party to the transaction. Currency swaps and currency futures are designed to reduce transaction risk. The first of these is premised on transferring the transaction exposure to another company. A second way in...
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