Contracts in a foreign country usually specify payments in the local currency, but there often are delays between the signing of the contracts and the closing of the deal. The dollar costs of such transaction depend upon the exchange rate. A company engaged in international transactions may be subject to Exchange Rate Risk. For example, a company may decide to buy a building in Germany for 3 million DM when the exchange rate is 3 DM/$ because that represents a cost of $1 million. But if the closing date on the purchase is 60 days ahead and in those 60 days the exchange rate goes from 3.0 to 2.7 DM/$ then the final cost of the building is not $1 million but $1.111 million. If this purchase were the only transaction for the company and it didn't take steps to reduce the risks, it had an exchange rate exposure of 3 million DM. Of course if someone owed the company 1 million DM then its net exposure to exchange rate risk is only 2 million DM.
A company can avoid exchange rate risk by dealing in the forward or future markets for the foreign currency. The company could have puchased in the 60 day forward market 3 million DM to cover the purchase price. The futures market is just a standardized forward market.
There is also a substantial transaction cost involved in the foreign exchange market. Often there is a fixed payment of say 4 percent plus a variable payment based upon the spread between the bid and asked prices for the currency.
There are greater time delays in international transactions in part because of less efficient mail system. But there is also the fact that international transactions require more participants. International wires of payments may have to be handled by five or six banks, each one of which is being very careful to make sure it is not going to be defrauded of a large sum of money. Many foreign banks practice what is called value dating. This means that in a transfer of funds the funds are withdrawn from an account one day are not deposited into the destination account until two days later. The transferer loses two days of interest, which is not an insignificant fee for the transfer of funds.
Trade requires trade documents and these have to be processed by several sets of bureaucrats and freight handlers. The diagrams below show the complexity of international transactions. In part, this complexity is necessitated because of the unlikelihood of collecting any overdue or defaulted payment.