If you import goods or sell your products and goods overseas, then the profit you make on a transaction partly depends on the exchange rate. Currencies fluctuate in value all the time. If there's a time lag between booking a transaction and paying for it, then there's a significant risk that the exchange rate will have changed in the interim. Transaction exposure measures the risk of such fluctuations resulting in a financial loss to the business.
Transaction Exposure Example
Suppose you export goods to a distributor in Europe to be paid in Euros having a value of $50,000. You operate on net-30 terms. However, next month, when the distributor comes to pay you, the exchange rate has changed. Now, the currency conversion translates to a $45,000 sale. You have suffered a $5,000 loss due to transaction exposure.
Transaction exposure is the risk that an exchange rate will change before the value of a transaction is settled. If the foreign currency goes up in value, it will cost more in the company's home currency. All businesses that engage in international trade face this risk. It is also known as a transaction risk, or a cross-currency risk, since the risk arises when a transaction involves multiple currencies.
How Do You Run a Measurement of Transaction Exposure?
The honest answer is you can't – at least not with any specificity. Exchange rates fluctuate for all sorts of reasons, and none of them are within your control. The most you can do is track historic exchange rates between the two currencies and use that as a baseline to predict currency fluctuations in the future. The website XE.com has a list of current and historical interest rates for just about every currency so you can track historical movements versus the U.S. dollar.
The length of the transaction matters. If you have a five-year supply contract, for example, then there's a much greater risk that the exchange rate will change – often multiple times and perhaps dramatically – across the life of the contract than if you had a one-time deal. For ongoing transactions, you may wish to get an automated currency feed so you can track exchange rate movements in real time.
When reviewing currency exchange rates, watch out for significant shifts from month to month or year to year. The exchange rate is one of the most significant determinants of a country's economic health. Volatile exchange rates might indicate an unstable economy, which would leave you with a large transaction exposure.
Gains and Losses On Currency Exchanges
What you can calculate with specificity is the actual gain or loss on a foreign currency transaction after that transaction has occurred. Suppose, for instance, that you invoice a British customer for £100. Income gets reported in your home currency using the exchange rate on the day the income was earned. In this case, you would figure out the exchange rate for the day you issued the invoice and enter the amount in U.S. dollars – let's say it's $125.
A few weeks later, the customer pays you £100 GBP. Now when you convert this sum to dollars, the money is worth $130. Since you earned $5 more than you reported, you must report a currency gain on your income statement. If the £100 converted to $120 USD, you would report a $5 currency loss. The gain/loss on exchange entry is essential for two reasons:
- You must report your financial statements in your home currency.
- Your assets must equal your liabilities on the balance sheet.
If you didn't record the currency gain/loss, then your balance sheet would go out of balance.
Transaction Exposure Vs Translation Exposure
Another term you may come across in this context is "translation exposure." This occurs when you denominate a portion of your assets, income or liabilities in a foreign currency, and the value of those items changes as a result of exchange rate fluctuations. Multinational corporations are likely to experience translation exposure since a portion of their operations will be based overseas.
Translation exposure is dangerous because it distorts the actual value of an asset as reported on the company's books. For instance, if you own a factory in Greece worth €500,000 and the €/$ exchange rate is 1:1, you'd report the value of the property as $500,000. But if the dollar-to-euro exchange rate became 1:2, the factory would show a much-reduced value of $250,000. This looks like you've lost $250,000 on the financial statements, even though you own exactly the same asset as you did before.
- exchange fluctuations image by Raimundas from Fotolia.com