The risk arises due to the fluctuation of currency rates. This risk relates to normal trading activities and short term in nature. Example: Export Receipt and Import Payment in the future. As this risk affects the cash flow, requires financial manager attention.
Definition of Transaction Risk
Transaction risk is the risk associated with the time delay between contract signing and settlement the agreed amount. Transaction risk will be higher if the time difference between the entrance of the contract and settlement of it is longer. Because there is more chances to fluctuate exchange rate during this period.
These risk may seriously affect the company’s cash flow, and in this situation, the company considers “Currency Hedge” to protect from unexpected cash flow shortage. Forward rate and currency Options is one of the best choices for Currency Hedging.
Transaction risk creates difficulties for individuals and corporations dealing in different currencies because exchange rates can fluctuate significantly over a short period. For sudden movement in foreign currency, a supplier may have to pay more capital in order to complete payment for the transaction in the supplier currency.
i) Short Term Cash Flow implications:
Transaction risks have short term cash implication. Example: Fratton Plc, UK sale Heavy Equipment to MZM Plc, USA and expects to receive the proceeds from MZM within 30 days. As the payment will be made after 30 days, so there is a chance to fluctuate Currency rate.
ii) Transaction Risks Can be Hedged:
These Risk can be Hedged by using different techniques. Forward Rate Agreement, Money Market Hedge, OTC Options etc. are the most common techniques for hedging transaction risk.