Transaction exposure occurs when a company enters into an agreement with a company who uses a different type of currency to pay for transactions in future periods. Transaction exposure also arises from having to pay for a transaction in a foreign currency denominated at a future period. Cash inflows and outflows that are to be paid in a foreign currency during a future period can cause either a gain or a loss for many companies if the exchange rate changes between the time the transaction is started and by the time the money is paid out. An example of transaction exposure would be when Best Buy purchases televisions for $500,000 from a manufacturer in Japan and the contract requires that the transaction be paid in Japanese Yen. The transaction exposure would occur at the moment that they classify that transaction an account payable because if the exchange rate changes when that amount is paid Best Buy would incur either a gain or a loss. The effect of the transaction exposure on a company depends on the degree that the change in the exchange rate affects the company. Many companies try to cope with transaction exposure by hedging. Hedging allows a company to offset the effect that the exchange rate has on a company by placing the company in a position where the gains of a company will balance the losses incurred. Some methods of hedging that are used to manage transaction exposure are risk shifting, currency risk sharing, currency dollars, cross-hedging, exposure netting, forward market hedge, and foreign options hedge. Some hedging methods allow a company to lock in a specific interest rate so that they can avoid dealing with losses that may arise from interest rate fluctuations that take place on a daily basis. Hedging however can sometimes also negatively impact a company in the event that a specific interest rate is locked in and when cash outflows take place the interest rate significantly drops because it can cause significant losses for the company that has to pay that liability.

Sources:

http://www.cgap.org/p/site/c/template.rc/1.9.3001/ accessed October 27, 2009.

http://www.allbusiness.com/finance/630482-1.html, accessed October 31, 2009.