BUSF_A01.qxd

Problems of internationalisation

Transaction risk

Suppose that a business buys something from a US supplier, which is priced in

dollars, at $100 at a time when £1 =$1.95. At that point, the business has an obligation

to pay the equivalent of £51.28 (that is, 100/1.95). Suppose also that, by the time that

the business comes to settle the bill, the exchange rate has depreciated to £1 =$1.70.

Now the amount that will actually have to be paid is £58.82. The problem here is that

when the business made a decision to buy the item the price was £51.28, but it then

turns out to be £7.54 higher. This risk is known as transaction riskbecause it is the risk

that the exchange rate will move in a direction adverse to the business partway

through a transaction.

There are ways of dealing with transaction risk, which we shall now consider

individually.

Doing nothing

The methods for dealing with transaction risk all seek to stop the worst happening, or

to make sure that the business does not suffer if it does. To this extent they are like

insurance policies, and they have costs associated with them. With most risks in our

personal lives we tend not to insure them unless the adverse event is unlikely to occur

and/or it will be very damaging if it does. The reason for this is that insurance pre-

miums are likely to be unreasonably high compared with the potential loss where the

loss is a likely one. Adverse exchange rate movements are very common. For example,

an ice cream seller could insure against spells of bad summer weather, but in the UK

there is such a likelihood of these occurring that the premiums would tend to be high.

Ice cream sellers tend to ‘self-insure’, that is, they bear the risk themselves. It is only

unlikely events or those that would lead to a very major disaster for the business that

are generally considered to be worth insuring against.

Future directions of movement of exchange rates are difficult, if not impossible, to

predict. If a business is owed money, denominated in a foreign currency, it is as likely

that the exchange rate will move in a favourable direction for the particular business

as it is that it will move in an unfavourable one – or it could stay the same. Thus a busi-

ness with a lot of foreign transactions will gain from an exchange rate movement as

often as it loses. It is only where the business is exposed to an unusually large, perhaps

isolated, transaction risk that it might feel the need to take steps to manage that risk

using one of the techniques explained below.

The portfolio effect is also an argument for not managing exchange rate risk. We

shall deal with this in section 15.5.

Trading in the home currency

It is possible for the UK business to avoid the transaction risk by insisting that pur-

chases and sales prices are denominated in sterling. This simply shifts the risk from

the business to its suppliers and customers. To the extent that it is common for sellers

to quote prices in the currency of the buyer, it will tend to be feasible to buy from

abroad and be invoiced in the home currency. When the time for settlement arrives,

sterling is paid. By the same token, however, foreign customers will usually expect to

be invoiced in their own currency. Insisting on invoicing in the home currency, and

shifting the transaction risk to the customer, may well lose sales (or be penalised by

having to accept lower prices). Also, insisting that all suppliers invoice in the buyer’s

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