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If a company has a contract to receive or to pay an amount in a currency other than its domestic currency, the risk that the value of that foreign currency may fluctuate against its domestic currency is referred to as a transaction exposure.

Transaction exposure relates to the actual conversion from one currency to another.

A transaction exposure is considered to have been 'born' when a contractual obligation arises to sell or purchase goods or services, or to receive or pay interest, royalties or other items, where the payment is denominated in a foreign currency.

It is the risk that occurs due to currency movement between the time a company becomes committed to an exchange rate in a transaction, and the settlement date of that transaction, and the time of establishing the conversion rate in a forward FX contract.

However, some companies will consider an exposure to have been born:

once a price list has been issued in a foreign currency.

Many companies obtain export business on the basis of a price list. With a foreign currency price list, the seller is exposed to fluctuations in the currency that may happen before the price list validity date expires. Whilst not a binding offer that is capable of acceptance under the laws of many countries, it could be commercially imprudent to reject an order based on a price list for any reason other than non-availability of goods.

from the agreement of 'a firm price'

This is the time that the FX rate to be protected from adverse movement is fixed.

when a currency invoice is received.

Many transactions do not have a formal contract and the first time the buyer knows the price in currency to be paid is when the supplier's invoice is received.

Even companies that operate exclusively on the domestic market may still find themselves subject to transaction exposures if they purchases goods from importers who source their purchases from overseas and pass the exchange risk on to the domestic company directly or indirectly.

Some transaction exposures are due to an underlying economic exposure. For example:

Tender to contract period: the period of economic exposure between quoting for a sale in a foreign currency and obtaining a firm order. On conclusion of the contract the economic exposure becomes a transaction exposure.

Investing in capital goods or services: the purchase or sale of capital goods denominated in a foreign currency. The risk arises when a decision to purchase or sell goods or services denominated in foreign currency has been taken, but a firm order has not been placed. This type of exposure is particularly noticeable when a company may negotiate with one or more suppliers over a protracted period of time.

Loan drawdown and repayment: The drawdown or repayment of loans denominated in foreign currency. Loan drawdown and conversion to invest could be subject to economic exposure. Loan repayment could be from revenues subject to economic exposure.

Dividends, royalties and interest payments: the payment or receipt of management fees, royalties, franchise or other licence fees denominated in a foreign currency. The risk arises from dividends not yet declared, royalties not yet earned, and interest not yet paid, etc.

There is an economic exposure on such items and there needs to be a policy decision to hedge or not to hedge such economic risks.

This judgement is important as only when an exposure is recognised and quantified can the appropriate corporate policy (i.e. full hedging, no hedging, active management, etc. - see below) be enacted.

Identification of the start of a transaction exposure can be extremely complex, particularly in big companies, because systems are required to collate large volumes of relevant information. Having identified the FX exposure the risk can be managed in many ways including use of the foreign exchange market.

In the foreign exchange market, FX dealers buy and sell currencies to satisfy the demands of traders, investors, tourists and speculators. They also use the FX market to hedge the currency holdings of their own bank.

The influence they exert through supply and demand on the rate of exchange (Spot Rate) creates volatility to a greater or lesser extent.

Volatility

Volatility for speculators is the oxygen they live on, however, for exporters and importers volatility is not a good thing. It creates uncertainty. Where there is uncertainty there is risk, and risks incur costs and profit erosion.

FX Risk = Financial Risk

FX exposures represent significant financial risk. The weakening of the US Dollar against and also the Euro has major implications:

Good for EU importers paying in US$
Good for US exporters to EU selling in Euro’s

As costs are lower, but,

Bad for EU exporters to

Bad for US importers from EU paying in Euros

Because costs are higher.

For an exporter receiving US Dollars this represents a potential loss. For a importer it is a significant cost increase, large enough to switch his source of supply to a new country with a rate of exchange to the US Dollar less volatile than , or to s competitor better able to manage the FX rate volatility.

To some extent exporters and importer's revenues and costs can be controlled, but FX markets cannot. However, companies can protect themselves against adverse FX movements if:

They understand the risks

They understand the FX hedging techniques
Their bank understands their business