The exchange rate chance dealing with the time delay between entering a contract and settling it. The greater the time differential, the greater the chances the two exchange rates change.
What is Transaction Risk?
Transaction Risk is the exposure to uncertainty factors that may impact the expected return from a deal or transaction. It can include but is not limited to foreign exchange risk, commodity, and time risk. It essentially encompasses all negative events that can prevent a deal from happening.
A deal with a high transaction risk will typically require a higher expected return; therefore, it is important to consider such risk when evaluating a prospective investment. In some instances, transaction risk can stop a deal from going through due to potentially negative outcomes associated with the transaction.
Common Transaction Risks
Some of the most common transaction risks that can affect the deal or transaction value include the following:
1. Foreign Exchange Risk
Foreign exchange risk is the unforeseen fluctuation of foreign exchange, which can affect the expected transaction value. This risk is especially important to consider for cross-border transactions or deals with countries that have relatively high currency volatility. Foreign Exchange Risk is also called economic exposure.
2. Commodity Risk
Similar to foreign exchange, commodity risk considers the unexpected fluctuation of commodity prices. While commodity fluctuation affects all sectors, it is a primary consideration in the Oil & Gas and Mining sectors.
3. Interest Rate Risk
Interest rate risk examines how interest rate fluctuation can affect transaction value. Depending on the changes in rates, this risk can affect the ability of the purchasing party to raise the necessary capital for the transaction and can impact the debt obligations of the selling party. For companies that engage in debt covenant agreements with financial institutions, interest rate fluctuation can impact the company’s ability to meet its obligations established in the covenant.
4. Time Risk
As market conditions and companies change with time, there is a higher probability that the initial transaction agreement conditions will become unfavorable the longer the negotiation process is extended. As a result, deals can fall through due to the favorable conditions no longer being present for both parties. The longer a deal takes to finalize, the longer the transaction is exposed to the other risks.
5. Counterparty Risk
When engaging in transactions, there is a risk that the counterparty will not complete their contractual obligations agreed upon in the transaction. In instances where counterparties default on their contractual obligations, it is often due to the effects of the previously stated transaction risks.