Transfer Risk Definition

What is transfer risk?

Transfer risk is defined as the threat that a local currency cannot be converted into the currency of another country due to changes in face value or due to specific regulatory or exchange restrictions.

Transfer risk, also known as conversion risk, can arise when a currency is not widely traded and capital controls prevent an investor or company from freely moving currency within or outside a country.

Key points to remember

  • Companies may encounter obstacles when doing business with companies abroad.
  • Transfer risk is an issue to be aware of and involves the threat of the inability to convert local currency into the currency of another country.
  • Timing issues associated with obtaining funds from a sale may prevent the currency from being converted to an appropriate amount.
  • Some companies maintain a transfer risk reserve allocated to combat transfer risks.
  • Companies that frequently do business with foreign companies are often better prepared to manage transfer risks.

How transfer risk works

The concept of transfer risk has become a significant issue over the past few decades as businesses began 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 various borders and helping to keep prices low for a variety of goods. However, purchasing goods from a company located on the other side of the world involves many risks.

For example, when a US company buys goods from a company in Japan, the transaction is usually denominated in USD Where japanese yen. These are frequently traded currencies, so it’s relatively easy for the US-based company to convert dollars to yen. Moreover, the United States and Japan have well-regulated and stable economies, which makes it possible to conduct transactions without any limitations. When it comes time for two international companies to do business, the choice of currency in an international transaction will often depend on the needs and wants of each individual company.

In some cases, the transaction is not as easy to complete. A company may buy 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 operate. Accordingly, these laws may affect the conduct of business, the processing of banking transactions and the delivery of products.

Businesses and corporations should always consider transfer risk issues when doing business with foreign companies and take steps to minimize the effects of these risks.

Special Considerations

A transfer risk puts a company in a tumultuous situation. That said, there are some steps one can take to limit the loss of capital. Some companies maintain a cash reserve, often referred to as an allocated reserve for transfer risk, to manage these challenges. This reserve is a provision that a company maintains to protect itself against country risks and inconvertible currencies.

The types of companies that maintain a transfer risk reserve vary, but can range from large multinational retail corporations to large banks with exposure in various countries. A banking institution may establish a allocated transfer risk reserve for Specified International Assets when required by the Board, in accordance with Federal Deposit Insurance Corporation (FDIC).

Example of transfer risk

Suppose a country’s banking regulations prevent a company from withdrawing funds from a foreign bank for several months after the sale is completed. While the funds are held, the value of the foreign currency decreases against the value of the currency of the country where the business is located.

The end result is losing money on the overall transaction simply due to a timing issue which must be followed by law. This is a transfer risk that some companies face when engaging in business transactions with companies from foreign countries.