Transaction Exposure

Transaction exposure is the risk that an unexpected change in exchange rates will affect the value of a firm's future foreign currency transactions. This can occur when a firm has a foreign currency-denominated asset or liability, or when it has a foreign currency-denominated transaction.

There are two types of transaction exposure:

• Translation exposure occurs when a firm's financial statements are translated from one currency to another. This can result in a gain or loss if the exchange rate changes between the time the financial statements are prepared and the time they are used for decision-making.
• Economic exposure occurs when a firm's future cash flows are affected by changes in exchange rates. This can occur when a firm has a foreign currency-denominated asset or liability, or when it has a foreign currency-denominated transaction.

Transaction exposure can be managed through a variety of techniques, such as hedging, diversification, and risk transfer.

Hedging is a technique used to reduce the risk of an adverse change in exchange rates. Hedging can be done by using a variety of financial instruments, such as forwards, futures, options, and swaps.

Diversification is a technique used to reduce the risk of an adverse change in exchange rates by investing in a variety of assets that are not correlated with each other. This can help to protect a firm from losses if one asset experiences a decline in value.

Risk transfer is a technique used to transfer the risk of an adverse change in exchange rates to another party. This can be done through a variety of financial instruments, such as forwards, futures, options, and swaps.

Transaction exposure is an important risk that firms should manage. By understanding the different types of transaction exposure and the various techniques available to manage it, firms can protect themselves from losses and improve their financial performance.