Transaction exposure in foreign exchange markets

Transaction Exposure

There are a number of factors that affect a firm's transaction exposure. The first is the volatility of the foreign and home country currencies. The second is the stability of the governments and economies in those countries, which will impact on the exchange rate volatility. Transaction exposure is also affected by the time frame between the cash flows -- the longer the time frame the greater the exposure. The size of the flows involved will also impact on the total exposure (Kelley, 2001). The degree of operating hedge will also determine the level of exposure that a firm has -- the more money kept in the foreign country, the lower the transaction exposure will be. The degree to which a firm is willing to price in a foreign currency is also worth considering -- American firms often can deal in dollars in foreign countries, eliminating transaction exposure entirely. An example of foreign exchange transaction risk would be a firm that sells €1 million worth of goods to a German company that pays in Euros. At the time of the deal, the contract equaled $1.35 million, but payment is not for three months. If the value of the Euro decreases to 1.32 in that time, the American company would still receive €1 million, but it would only be worth $1.32 million, so the F/X loss would be $30,000. The possibility of such a loss is the result of the exposure that the firm has taken by selling in euros, while its costs are in dollars. This exposure could result in a profitable transaction becoming unprofitable, so foreign currency transaction risk is something that most firms wish to avoid or mitigate.

Many international corporations engage in hedging with respect to transaction risk that derives from their foreign currency flows. In 2007, for example, Google began actively hedging transaction exposure. They had already been hedging translation risk to that point, but added transaction risk hedging at this point. The company built a mock trading floor and put together a foreign exchange trading staff in order to protect against adverse currency movements on foreign exchange transactions (Phillips, 2011).

Firms that are subsidiaries of foreign firms are likely to engage in hedging. Such firms will often have transactions between subsidiary and head office that involve foreign exchange. For a firm like Millipore, a subsidiary of Merck, it is likely that transactions with headquarters are done in the currency of headquarters, in this case the euro. As a result, these companies maintain foreign currency trading desks to hedge the transaction risk that they face as a consequence of such dealings (Myers, 2010).

In order to address its foreign currency transaction risk, some firms prefer to finance locally. McDonald's, for example, has a number of strategies that it uses to hedge its exposure to transaction risk. The company prefers, where possible, to finance locally and to purchase its supplies locally as well. This allows it to keep revenue in foreign countries, reducing the overall amount of transaction risk that it faces with such operating hedges. As a result, approximately 40% of the company's debt is denominated in foreign currencies, primarily the pound, euro, and the Australian and Canadian dollars. While this strategy still leaves McDonald's exposed to translation risk, it greatly reduces the firm's total transaction risk, because it reduces the overall percentage of transactions that involve foreign exchange (Gasparro & Stynes, 2011).