This guide is provided by Alt21 Limited, trading as Alt21, an FCA authorised payments and FX provider and is intended for UK businesses considering FX hedging as part of their treasury activity. All examples provided are illustrative only and not a current or guaranteed rate. Please read the full disclaimer at the bottom of the page.
If your business invoices customers or pays suppliers in another currency, the amount you receive or pay in sterling may differ from what you expected when you agreed the deal. That’s transaction risk, and it can affect your cash flow, margins and financial planning.
In this guide, we’ll explain how transaction risk works, where it arises and how to assess your exposure. We’ll also explore practical ways to manage it, from adjusting payment terms to using FX hedging instruments.
Quick summary
- Transaction risk is the chance exchange rates move before a foreign currency deal settles.
- It changes what you receive from customers or pay suppliers.
- Longer payment terms mean a longer exposure.
- Exposure can start at the quote, not only the invoice.
- Unlike translation risk, it affects cash and profit or loss.
- Assessment means mapping, netting and stress-testing exposures.
- Management ranges from contract terms to forwards and options.
What is transaction risk?
Transaction risk, also called FX transaction risk or foreign currency transaction risk, arises whenever a business agrees a payment or receipt in a currency other than its own and settles it at a later date. The price is fixed in the foreign currency, but its value in your home currency stays open until the money changes hands.
For exporters, transaction risk applies to receivables. A UK business that invoices a customer in euros knows how many euros it will receive, but not how many pounds those euros will convert into on the payment date. For importers, it applies to payables. A business paying a supplier in US dollars knows the dollar amount it owes, but not what that will cost in sterling or euros when it pays.
Exchange rates can move in either direction, so the result at settlement may be better or worse than the rate on the day of the deal. The core issue is uncertainty. You can’t say in advance what the transaction will be worth in your own currency, which makes cash flow forecasting and margin planning harder.
Payment terms set the length of the exposure. A 30-day invoice is open to rate movements for a month, a 120-day invoice for four months.
Transaction risk in practice: a worked example
All figures and rates in this example are illustrative. A UK manufacturer supplies equipment to a customer in the Netherlands and invoices €500,000 on 90-day terms. Its costs for the order, paid in sterling, come to £400,000.
| At invoice | At settlement (90 days) | |
| GBP/EUR rate (illustrative) | 1.15 | 1.18 |
| Sterling value of €500,000 | £434,783 | £423,729 |
| Cost of the order | £400,000 | £400,000 |
| Margin | £34,783 (8.0%) | £23,729 (5.6%) |
On the invoice date, €500,000 converts to £434,783, which gives an expected margin of £34,783 (8.0%). Over the next 90 days, sterling strengthens against the euro from 1.15 to 1.18 euros per pound. Each euro now buys fewer pounds, so the same €500,000 converts to £423,729 when the customer pays. The margin is now £23,729 (5.6%).
The customer has paid in full and on time, but the business receives £11,054 less than it planned for. A rate move of around 2.6% has reduced the margin on the order by almost a third. That’s because the whole shortfall comes out of an 8% margin, not out of the full invoice value.
Had sterling weakened to 1.12 instead, the same invoice would have converted to £446,429, a gain of £11,646. But neither outcome can be known when the invoice is issued.
The same applies in reverse for importers. An Irish distributor owes a supplier $300,000 in 60 days, with EUR/USD at 1.10 when it places the order. If the euro weakens to 1.06 by the payment date, the cost rises from €272,727 to €283,019, an extra €10,292.
Types of transaction risk
Transaction risk doesn’t begin when you issue an invoice. It’s usually divided into three stages, each covering a different part of the sales or purchasing cycle.
Quotation exposure
Sometimes called pre-transaction or pricing exposure, it runs from the moment you quote a price in a foreign currency to the point the customer accepts it. If rates move while a quote is open, the margin built into that price may be smaller than you expected.
Backlog exposure
Runs from the agreed order to the invoice. The price is fixed, but nothing has been billed yet. For businesses with long production or delivery lead times, this stage can last several months.
Billing exposure
Runs from the invoice to payment. This is the stage most finance teams track, because the amount is recorded in receivables or payables on the balance sheet.
Three factors tend to increase exposure at every stage:
- Payment term length. Longer terms extend the period over which rates can move.
- Currency volatility. Some currency pairs have historically moved more than others over the same period.
- Contract currency. Agreeing to trade in a foreign currency keeps the exposure with you, while trading in your home currency passes it to your customer or supplier.
Transaction risk vs translation and economic risk
Transaction risk is one of three main types of currency exposure, alongside translation risk and economic risk.
While all three arise from exchange rate movements, they affect businesses in different ways.
Transaction risk
Transaction risk arises when a business agrees to pay or receive money in a foreign currency, and the FX exchange rate changes before the transaction is settled. This can affect the final cost or value of the payment.
Translation risk
Translation risk arises when a business converts the financial results of its overseas operations into its reporting currency. Exchange rate movements can change the reported value of those operations without necessarily affecting cash flow.
Economic risk
Economic risk refers to the longer-term impact of exchange rate movements on a business’s competitiveness and future cash flows. For example, a sustained rise in sterling could make UK exports more expensive for overseas customers.
For businesses making or receiving international payments, transaction risk is often the most immediate concern because exchange rate movements can directly affect the amount they ultimately pay or receive.
Learn more about exchange rate management.
How to assess transaction risk
You don’t need specialist software to start assessing transaction risk. Your existing financial records and a spreadsheet can help you identify where your business is exposed to exchange rate movements and how significant the potential impact could be.
Transaction risk assessment generally involves five steps:
1. Map your exposures
List your foreign currency receivables and payables, including confirmed orders and open quotes as well as issued invoices. Record the currency, amount and expected settlement date for each.
2. Net offsetting positions
Look for foreign currency inflows and outflows that could offset each other.
For example, if you expect to receive €200,000 and pay €150,000 around the same time, your net exposure could be €50,000 rather than the full €200,000.
However, timing matters. If your supplier payment is due before your customer pays, you may still need to purchase euros in the meantime. Consider both the amounts and settlement dates when calculating your net exposure.
3. Group by settlement date
Organise your exposures into time periods, such as months or quarters. This helps you see when payments are due, how much currency you expect to receive or pay and where your largest translation exposures sit.
4. Run a sensitivity check
Calculate how changes in exchange rates could affect the value of your exposures in your home currency.
For example, at GBP/EUR 1.15, a 5% strengthening of sterling would reduce the value of a €500,000 receivable by approximately £20,700.
Compare the potential change with your expected margins and cash flow forecasts to understand its significance.
5. Decide what’s material
Determine how much exchange rate movement your business is prepared to absorb, whether that’s a monetary amount or a percentage of expected margin or profit.
This can help you prioritise which exposures warrant closer attention and where you may want to consider ways to manage them.
How to manage transaction risk
Managing transaction risk usually combines operational approaches, which change how the business trades, with financial instruments, which can fix or cap the rate on specific transactions.
The right mix depends on the business’s cash flows, the size and timing of its exposures, and its commercial objectives.
Natural and operational approaches
Invoicing in your home currency
This passes the exposure to your customer or supplier, which may affect pricing if they prefer to trade in their own currency.
Matching inflows and outflows
A natural hedge uses revenue in one currency to pay costs in that currency, so less needs converting. It works best when amounts and timings broadly match.
Netting
Amounts owed and receivable in the same currency, within a group or with one counterparty, are offset so only the balance is exchanged.
Adjusting payment timing
Moving payments earlier or later, within agreed terms, changes when exposure arises, but relies on a view of where rates are heading.
Financial instruments
Note: Forward contracts and FX options can help manage exchange rate risk, but they carry risks of their own and are not suitable for every business. Before entering into any FX product, you should consider whether it is appropriate for your needs and circumstances.
Forward contracts
With a forward contract, you agree to exchange a set amount of currency at a fixed rate on a future date, so you know the rate in advance. In return, you’re committed to the contract: you must settle it even if the market later moves in your favour. Forwards may also involve margin requirements and carry counterparty and settlement risk.
FX options
With an FX option, you pay an upfront premium for the right, but not the obligation, to exchange currency at an agreed rate. This can provide a worst-case rate while leaving room to benefit from favourable moves.
The premium is non-refundable whether or not you use the option, and it adds to the overall cost. Options are also more complex than forwards, so it’s worth understanding how they work before using one.
Businesses may be able to apply hedge accounting under IFRS 9 1, subject to meeting its qualifying criteria. This is designed to align the timing of gains and losses on hedging instruments with the hedged transactions.
Some finance teams formalise all of this in a written hedging policy, recording which exposures they manage, the thresholds for action, the instruments they’ll use and who can approve trades.
With an agreed policy, the team can decide on a consistent basis, and the board and auditors can see how currency exposure is handled.
Alt21 Limited is authorised and regulated by the Financial Conduct Authority (FRN: 783837) and is a company registered in England and Wales (number 10723112). The registered address is 45 Eagle Street, London WC1R 4FS, United Kingdom. This article has been produced by Alt21 Limited for information purposes only. It does not constitute financial advice or an offer to sell or the solicitation of an offer to buy any products referenced. Hedging products are not suitable for every business. Before entering into any FX product, you should consider whether it is appropriate for your needs and circumstances. Alt21 Limited assumes no liability for errors, inaccuracies or omissions. Eligibility criteria and terms and conditions apply to all products and services offered by Alt21 Limited. Not all applications will be accepted.
