Transaction Risk is the exposure to uncertainty factors that may impact the expected return from a deal or transaction. It can include but is not limited to foreign exchange risk, commodity, and time risk. It essentially encompasses all negative events that can prevent a deal from happening.
A deal with a high transaction risk will typically require a higher expected return; therefore, it is important to consider such risk when evaluating a prospective investment. In some instances, transaction risk can stop a deal from going through due to potentially negative outcomes associated with the transaction.
Common Transaction Risks
Some of the most common transaction risks that can affect the deal or transaction value include the following:
1. Foreign Exchange Risk
Foreign exchange risk is the unforeseen fluctuation of foreign exchange, which can affect the expected transaction value. This risk is especially important to consider for cross-border transactions or deals with countries that have relatively high currency volatility. Foreign Exchange Risk is also called economic exposure.
2. Commodity Risk
Similar to foreign exchange, commodity risk considers the unexpected fluctuation of commodity prices. While commodity fluctuation affects all sectors, it is a primary consideration in the Oil & Gas and Mining sectors.
3. Interest Rate Risk
Interest rate risk examines how interest rate fluctuation can affect transaction value. Depending on the changes in rates, this risk can affect the ability of the purchasing party to raise the necessary capital for the transaction and can impact the debt obligations of the selling party. For companies that engage in debt covenant agreements with financial institutions, interest rate fluctuation can impact the company’s ability to meet its obligations established in the covenant.
4. Time Risk
As market conditions and companies change with time, there is a higher probability that the initial transaction agreement conditions will become unfavorable the longer the negotiation process is extended. As a result, deals can fall through due to the favorable conditions no longer being present for both parties. The longer a deal takes to finalize, the longer the transaction is exposed to the other risks.
5. Counterparty Risk
When engaging in transactions, there is a risk that the counterparty will not complete their contractual obligations agreed upon in the transaction. In instances where counterparties default on their contractual obligations, it is often due to the effects of the previously stated transaction risks.
How to Manage Transaction Risk
To mitigate the effects of transaction risk, some precautions each party of the deal can take include the following mitigation techniques. These methods used for transaction risk management are often included in transaction contract clauses or within the deal process.
Companies will engage in hedging arrangements to reduce the level of potential risk from the price movement of various assets. Hedging provides companies with protection against adverse changes to asset prices that can negatively affect investment.
Within the context of transactions, companies will often complete hedging arrangements to reduce the effects of Foreign Exchange and Commodity Risk associated with the deal. To learn more about Hedging specific to the context of foreign exchange exposure, please see the article titled “Economic Exposure.”
In a fluctuating interest rate environment, companies often look to refinance their debt when interest rates are declining. Debt refinancing allows companies to reduce their debt obligations and to borrow at more attractive rates. To ensure that a party is eligible for refinancing, the borrowing party can include renegotiation clauses in their contracts that allow for refinancing adjustments when notable interest rate changes.
To reduce the possibility of the counterparty defaulting on their contractual obligations, parties will undergo an extensive due diligence process to assess various components of the transaction before coming to an agreement. In situations where the counterparty has a higher risk of defaulting, the purchasing party may place a default risk premium into the transaction agreement to create an incentive for taking on more risk.
Including Risks in Financial Models
When including assumptions in a financial model, analysts will often include predictions for commodity prices, interest rates, and other factors associated with transaction risk. Including these assumptions allows analysts to provide comprehensive considerations in their models, leading to better investment decisions. To consider the profitability of an investment in both best and worst-case scenarios, analysts can adjust the prices in these situations according to how they expect market conditions.