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For many businesses, growth and scaling require expanding their reach to international shores. But with this international trade comes a new dimension of risk, especially given the volatile nature of foreign currencies.
International trade opens up a host of new opportunities, but it can also open up new vulnerabilities that should be factored into your risk assessment. Here, we’ll look at the transaction risks that can occur when Australian businesses buy and sell goods from overseas.
Transaction risk explained
Transaction risk is one of several foreign exchange risks that companies face when they trade internationally. It is tied to economic risk / forecasting risk and can cause fluctuations in profits that might negatively impact cash flow.
When companies buy or sell products from overseas companies the foreign exchange rate can have a negative impact on the completed transaction. When the supplier’s currency appreciates but the buyer’s currency depreciates, the wholesale cost of the item requires a larger financial commitment from the buyer to meet the contracted price.
The more time elapses between entering into and settling a contract with a supplier, the more risk the buyer incurs. Thus, businesses can mitigate their risk with the right types of contracts, strategic hedging and making use of financial offerings overseas.
Transaction risk example
Let’s say your Australian company also has operations in the US. In this instance, your earnings in USD would need to be brought to your AUD account. At the time of writing, the rate of exchange is roughly AUD 7.3 to USD 1. A transaction with a value of US$1,000 would net you around A$1,370.
However, if the US dollar were to surge in value before the transaction is completed, the value of the transaction would be reduced by the exchange rate. So a company expecting A$1,370 would get only A$1,250 if the exchange rate were to change from AUD 7.3 to AUD 8.0 to USD 1 – a loss of A$120.
How does transaction risk affect businesses?
A single loss of this kind may prove fairly negligible to a business. But if your company makes high volumes of transactions with overseas suppliers, these losses can put a significant dent in your profit margins.
This may result in a loss of operating capital, which in turn may impede your scalability.
Fortunately, while businesses cannot control the exchange rates, they have a number of tools at their disposal to minimise their risk and protect their profits.
Managing transaction risk
Transaction risk can never be completely avoided. There are too many macroeconomic factors at play over which companies have no control. However, there are tools and strategies that they can deploy to manage their risk.
Overseas bank accounts – Perhaps the easiest way to manage transaction risk is to open up bank accounts in countries where you’re likely to have a lot of transactions. Surplus currency can be deposited into these accounts and held until exchange rates are more favourable.
Forward exchange contracts – Exchange rates are locked in until an agreed date to protect the buyer from shifts in the vendor’s favour (although this also means there’ll be no shifts in the buyer’s favour either).
Spot transactions – This is where the contract is settled on the spot, so there is no time for exchange rates to fluctuate.
“Perfect” hedging – This is where a company matches any outgoing payments in foreign currencies against inflows of the same currency received at the same time. Hence the term ‘perfect’ hedging.
We Can Help
If you’re interested in finding out more about transaction risk and how to mitigate it, then get in touch with our financial experts. Discover how GoCardless can help you with ad hoc payments or recurring payments.