THE NATURE OF TRANSACTION EXPOSURE.
This is how foreign exchange risk is created, the inherent features, character, or qualities of foreign
exchange risk.
According to Vyuptakesh Sharan in his work on international financial management, they are:
i). Arises from Contractual Obligations:
Transaction exposure occurs when a company enters into a contractual agreement that involves buying
and selling goods and services in a different (foreign) currency, such as exporting sales, importing
purchases, or borrowing/repayment in foreign currencies. For example, if a U.S. company enters into
contract to sell goods to a European buyer for €100,000 payable in some months, any appreciation or
depreciation (fluctuations) of the euro against the dollar during that period increases or decreases the
dollar value of that receivable upon payment.
ii). Short-Term in Nature:
Unlike economic or translation exposure, transaction exposure is typically short-term, as it is linked to
specific transactions with defined settlement dates or arises from contractual obligations, such as
imports or exports, that are typically settled within a relatively short period, usually less than a year. For
example, a US-based company imports goods from Japan with a payment term of 90 days. and the yen
appreciates against the US dollar during this period, resulting in a transaction exposure loss since more
dollars are paid to settle the invoice.
iii). Focused on Cash Flow Impact:
Cash flows from transactions such as imports and exports, foreign currency loans, or cross-border
investments could be impacted due to exchange rate fluctuations between the time the transaction is
initiated and when it is completed. This could either increase costs such as those of imports or reduce
revenues such as those of exports. For instance, if a U.S.-based company exports and agrees to receive
payment in euros from Europe, a rise in the euro's value against the dollar before receiving payment
could positively impacting cash flow, and vice versa.
iv). Influenced by Exchange Rate Volatility (likeliness to change suddenly):
A company faces risk when it has outstanding financial obligations or receivables denominated in foreign
currencies. The degree (level) of transaction exposure depends on the volatility of the foreign currency
involved. Greater volatility increases the risk of adverse exchange rate movements. Example, from
Germany, with an initial exchange rate of R$100,000 = €1,000. If suddenly the exchange rate becomes
R$100,000 = €800, Azul would need to pay more Brazilian reais to buy the same spare parts.
v). Dependent on Timing:
The timing of the transaction plays a crucial role. The longer the time gap between the agreement and
settlement of the transaction, the greater the exposure (subjection) to exchange rate changes. Due to
timing, the expected exchange rate is different from the actual exchange rate at the time of transaction.
For example, when a US company sells goods to a British firm, if the dollar appreciates against the
pound before the payment date, the US company receives fewer pounds than anticipated.
vi). Can Be Hedged (protected against risk):
Transaction exposure is manageable through financial instruments such as forward contracts, futures,
options, and swaps, or by operational techniques like matching currency inflows and outflows. For
example, a US-based company, XYZ Inc., expects to receive €1 million from a European customer in 90
days. To hedge transaction exposure, XYZ Inc. can enter into a forward contract with a bank, locking in
an exchange rate of $1.20/€1, ensuring that it receives $1.2 million in 90 days. Alternatively, XYZ Inc. can
also buy a futures contract or purchase an option to exchange €1 million for US dollars.
1.2.MEASUREMENTS OF TRANSACTION EXPOSURE.
. The measurements of transaction exposure, as discussed by Sharan, typically include the following:
1. Net Transaction Exposure:
This measures the difference between foreign currency inflows and outflows over a certain period. It
accounts for all receivables and payables in foreign currencies to determine the net exposure.
2. Value at Risk (VaR):
VaR quantifies the potential loss in value of foreign currency transactions due to adverse exchange rate
movements within a given confidence level and time horizon.
3. Sensitivity Analysis:
This approach assesses the impact of various exchange rate scenarios on the company’s foreign
currency-denominated transactions. It allows firms to understand how sensitive their cash flows are to
exchange rate changes.
4. Scenario Analysis:
This method involves analyzing the impact of different hypothetical exchange rate scenarios on the
company’s financial position. It helps assess the range of possible outcomes due to exchange rate
fluctuations.
5. Cash Flow Mapping:
This involves identifying and mapping all foreign currency inflows and outflows to measure the risk of
mismatched cash flows caused by exchange rate changes.
Nature of translation exposure
How is translation exposure measured?
Nature of economic exposure
How is economic exposure measured?
