Transaction Exposure is also known as Economic Exposure. It is the risk faced by companies who trade internationally or do business globally. Transaction Exposure occurs when exchange rates change after firms have already signed a financial obligation contract. Thus, transaction exposure can be denied as the loss caused by exchange rates when a firm’s Accounts Payable and/or Receivable are denominated in foreign currency.

The fluctuation in exchange rates can lead to big losses for firms. In such situations, firms choose a hedging strategy such as forward contracts, options, or futures to mitigate transaction exposure. For example, a US company has a manufacturing plant in Mexico where all operations are paid in Mexican Pesos. In this case, the company faces Transaction Exposure because they would need to pay rent, utilities, employees, etc in Mexican Pesos. If the exchange rate between the dollar and the peso change in favor of the peso; meaning that the peso appreciates, then the US firm will have less purchasing power. In this situation the firm will spend more dollars to pay off liabilities in the foreign country where they operate their manufacturing plant. It is obvious that the exchange rate in favor of the peso does not benefit the US firm. On the other hand; the US firm will have more purchasing power if the exchange rate favors the dollar. In this case, the exchange rate change benefits the firm.

Exchange Rates not always benefit a firm and these rates are subject to sudden change depending on global demand, political issues, etc. So a firm must always have a hedging strategy to mitigate Transaction Exposure. A suggestion to all firms to reduce losses from Transaction Exposure is to have less cash denominated in soft currency or foreign currency, have all assets denominated in hard currency or home currency. The other strategies that were mentioned before are forward, futures, and option contracts.

Sources:

Foundations of Multinational Financial Management, Wiley Custom Services, 2009.