What is Transaction Risk?
How Does Transaction Risk Work?
Companies often engage in transactions involving more than one currency. In executing these transactions, companies must repatriate any foreign currencies received as payment. This repatriation occurs at a market exchange rate which is vulnerable to fluctuation. These transactions usually comprise a lag between execution and settlement. In this respect, transaction risk is the risk that the relevant exchange rate will unfavorably fluctuate during this lag, resulting in potentially serious losses to the company in question.
To illustrate, suppose there is a three-day lag between a transaction's execution and settlement. The company is receiving payment in GBP which they must repatriate into USD -- their local currency. Transaction risk is the risk that the GBP-USD exchange rate will decrease during this three-day lag.
Why Does Transaction Risk Matter?
Transaction risk increases as the time lag widens between a transaction's execution and settlement. Just as transaction risk comprises the risk of loss, it also comprises the possibility of gains should a favorable exchange rate movement occur.