Answer to Question #120742 in Accounting for kalab

Question

explain detail transaction processing risks with example

Answer 1

Transaction processing risks

Transaction processing risk refers to the adversities resulting from uncertainties engaging in foreign exchange transactions, commodity, interest rate, contractual forfeiture by party as well as time lapse risk the transaction of which may potentially result in loss of expected returns. Organizations engaging in sale, lease, purchase, loan or investment agreements with other firms located in other countries incur costs associated with the currency and time lag between entering a contract and actually executing it. These costs eat into the profits remitted. The greater the time lag, the higher the transaction risk, as a result of more time for the exchange rate to fluctuate. At the end of it all, there is always one party of the transaction who gets to benefit.

Example

If an organization in the United States engages in a deal with a European company, and the U.S. Company requires repatriating profits from a sale in Euros, it will have to exchange Euros at a certain EUR/USD exchange rate. If the Euro was to depreciate, the company would end up receiving less $’s. If for example the exchange rate between EUR/USD was 1.5, the amount of 1,000 Euros the expected amount to be repatriated would be $1,500. At the instance that the exchange rate would fall decline to 1.00 during settlement, the company would end up receiving $1,000 resulting to a transaction risk loss of $500.

Minimizing Transaction processing risks

Organizations can minimize transaction processing risks by hedging, due diligence or refinancing. With a forward contract for example, a company can lock the currency rate for a set date in the future. Moreover, by purchasing options, a company can set ‘at-worst’ rate for the transaction and in case the option expires out of the money; the organization will have the option of executing the transaction in the open market at a favorable rate.