What Is Transfer Risk?
Transfer risk is defined as the threat that a local currency can't be converted into another nation's currency due to changes in nominal value or specific exchange restrictions. The transfer risk, also known as conversion risk, may arise when a currency is not widely traded and capital controls prevent an investor or business from freely moving currency in or out of a country.
- Companies may face hurdles when conducting business with companies overseas.
- Transfer risk is one issue to be aware of and involves the threat of the inability to convert local currency into the currency of another nation.
- Timing issues associated with getting funds from a sale may prevent the currency from being converted into the proper amount.
- Some companies maintain an allocated transfer risk reserve to combat transfer risks.
- Companies that frequently do business with overseas companies are often better prepared to handle transfer risks.
How Transfer Risk Works
The transfer risk concept became a prominent issue in recent decades when businesses started to make international trade a large part of their normal operations. The benefits associated with international trade include increasing the flow of goods and services across the various borders and helping to keep prices low for a variety of goods. However, there are quite a few risks involved with buying goods from a company on the other side of the globe.
For example, when a U.S. company buys goods from a company in Japan, the transaction is typically denominated in USD or Japanese Yen. These are frequently traded currencies, so it is relatively easy for the U.S.-based company to convert dollars into yen. Plus, both the U.S. and Japan have well-regulated and stable economies and this allows transactions to be conducted without any limitations. When the time comes for two international companies to do business, the choice of currency in an international transaction will often depend on the needs and desires of each individual business.
In some cases, the transaction is not as easily conducted. A business may purchase goods from a company located in a foreign country where it is more difficult to convert the currency. Companies are subject to the laws of the country where they do business. As a result, these laws may affect how business is conducted, how bank transactions are processed, and how the products are delivered.
Companies and corporations should always consider transfer risk issues when doing business with foreign companies and take the necessary steps to minimize the effects of these risks.
A transfer risk puts a business in a tumultuous situation. With that said, there are certain measures one can take to limit the loss of capital. Some firms keep a reserve of cash, often known as allocated transfer risk reserve, to manage these challenges. This reserve is an allowance a company maintains to protect against country risks and inconvertible currencies.
The types of companies that maintain a transfer risk reserve will vary but can include large retail multinationals to large banks with exposure in various countries. A banking institution may establish an allocated transfer risk reserve for specified international assets when required by the Board, according to the Federal Deposit Insurance Corporation (FDIC).
Example of Transfer Risk
Suppose banking regulations in a country prevent a business from withdrawing funds in a foreign bank for several months after the sale has been completed. While the funds are being held, the value of the foreign currency decreases relative to the value of currency from the country where the business is located.
The end result is losing money on the overall transaction simply due to a timing issue that must be followed in accordance with the law. This is a transfer risk that some businesses face when engaging in commercial transactions with companies in foreign countries.