The transaction risk has to do with the amount of risk that is incurred during the period of time that occurs between entering into some type of agreement or contract, and when the contract is finally settled. While the purchase of just about any type of security can involve some potential for changes during this period, the risk is usually higher in markets where changes take place quickly. One of the most common types of transaction risk has to do with shifts in the relative value of various currencies that are involved with the transaction.
One example of transaction risk has to do with the creation of a contract between two companies, with each company based in a different country. Typically, the terms of the contract will specify the type of currency that will be used to remit payments. The hope of both parties is that the exchange rate between the currency of the buyer and the currency of the seller will remain more or less the same until the contract is fully settled. If the rates do remain relatively stable, then both parties emerge from the deal with what they expected to gain from the transaction. Should the exchange rate shift significantly, one party stands to gain a great deal more while the other party incurs a loss.
When entering into any type of transaction where there is potential for some sort of adverse change to occur before the contract is settled, both the buyer and the seller should look closely at the possible shifts and identify ways to minimize any loss that could result. The actions taken to contain the degree of risk will vary, based on what circumstances may increase the risk. Containing transaction risk in the event of a possible political issue would be somewhat different from working with the occurrence of a natural disaster, and would require a different response in order to minimize the impact of the event on the transaction.
There are a few basic strategies that can help reduce transaction risk in many situations that do not come about due to catastrophic events. One approach is to make use of various currency swaps that help to minimize the impact of constantly changing exchange rates. This can be a somewhat complicated process that involves multiple trades of multiple currencies. While time consuming, this approach can often allow both parties to emerge from the deal feeling as if they received the benefit desired from the contract, with neither party sustaining any significant loss.
