Transaction exposure results from transactions that give rise to known, contractually binding future foreign – currency – denominated cash inflows and outflows, a risk faced mostly by companies that are involved in international trade. As exchange rates change between now and the transactions settlement date, so does the value of their associated foreign currency cash flows. This changing of the exchange rates after the companies have already entered into financial obligations, in terms can lead to currency gains and losses. In order to not experience any losses, it is crucial to manage transaction exposure. Statistics show that in today’s economy over 90% of businesses manage their transaction risk. Corporations, most often do so by purchasing various derivatives, mostly forward contracts. Besides forward market hedge, there are 6 other common methods of hedging transaction exposure. Those include risk shifting, currency risk sharing, currency collars, cross – hedging, exposure netting, and foreign currency options.

Examples of transaction exposure for a US company would be the accounts receivables associated with a sale denominated in euro or the obligation to repay a Japanese yen debt.

In those cases corporations have the chance to hedge transaction exposure by using one of the 7 methods, described above.

The methods of currency risk sharing and currency collars are almost identical, whereas the currency collars method is the more formal arrangement. Both make use of “the Zone”, an area in which exchange rate changes cause no direct action, as risk is not shared. Currency risk sharing and currency collars are used to hedge against currency moves outside this neutral zone. By putting forward contracts in place, corporations convert their foreign currency denominated currency at the zone forward rate, and protect themselves from transaction exposure. As forward contracts are not available in certain currencies, the method of cross – hedging (a forward contract in a related currency, whereas a correlation between the two currencies is critical to the success of this hedge) is another common way to hedge transaction exposure.

Works cited

http://fxbestpractices.com/forums/t/143.aspx