The value of your investments is significantly impacted by changes in global currency exchange rates. It's important for investors to consider the dramatic influence that the foreign exchange market has on the stocks they own. Do you know what currency exposure your portfolio has?
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Currency and Transaction Exposure
Exchange rates impact investors around the world. For instance, investors in automaker Toyota Motor Corporation have currency exposure from the company selling cars outside of Japan. Toyota sells cars around the globe, receiving dollars in the U.S., euros in France and rupees in India. After receiving these foreign currencies, Toyota converts back to the domestic currency (yen). Changing exchange rates influence the value of what Toyota receives when they convert currencies, and investors in Toyota are impacted by this activity. Likewise, Barrick Gold Corporation investors have currency exposure from selling outside Canada, as do investors in mining conglomerate BHP Billiton Limited, due to sales outside of Australia.
Investors have currency exposure because of the transaction risk faced by companies involved in international trade. This is the risk that currency exchange rates will change after financial obligations have already been entered into. The currency exposure of an asset, such as stocks, is the sensitivity of that asset's return, measured in the investor's domestic currency, to fluctuations in exchange rates.
Investors, as owners of companies and assets, have currency exposure through exchange rate fluctuations. With an understanding of this exposure, investors should know how these factors could affect the performance of the assets in their portfolio.
The Global Power of Forex
Real exchange rate movements may have a significant influence on economies and international corporations. As real exchange rates go up and down, the earnings, costs, margins and operating incentives of companies change.
Let's look at a hypothetical example using French tire manufacturer Michelin. Assume that the euro, appreciates (i.e., increases) substantially against a variety of currencies. Michelin is affected in a variety of ways.
First, the appreciation of the euro would affect the entire French economy. French goods would become more expensive, because it takes more foreign currency to purchase francs. Thus, net exports outside of Europe would likely decrease. Michelin, as an exporter from France, would be selling more expensive products overseas and would probably experience a decrease in total sales. If sales did indeed decrease, Michelin's profitability would be hurt and the stock price may decline.
Alternatively, if the franc were to depreciate substantially against a basket of currencies, Michelin tires would become price competitive. Sales would likely increase and the profitability of Michelin may improve. Moreover, Michelin could lower their selling price in foreign markets without hurting margins and there would be incentives to produce products in France where production costs are lower.
Based on the above impacts that exchange rates can have on a company's operating performance, it's clear that stock prices are influenced in turn.
Investors should note the impact that the U.S. dollar exchange rate has on all assets. Many raw materials, including oil, are priced in dollars. U.S. dollar depreciation typically increases the price of raw materials, while a dollar appreciation tends to decrease commodity prices. This unique relationship should be factored into any currency exposure analysis.
What's Your Exposure?
There are very useful relationships that can be observed between changes in exchange rates and investable assets. Most investors are impacted by these changes via stocks (although other assets, including fixed income, commodities and alternative assets, are influenced by changes in global exchange rates). There are three general correlations between stock price performance and exchange rate fluctuations: zero correlation, negative correlation and positive correlation.
Zero correlation - When there is no reaction by stock price to changes in exchange rate, there is zero correlation. An example of zero correlation is if the stock price of American electronics device producer Apple Inc. doesn't change, while the U.S. dollar fell 1% in value.
Negative correlation - A negative correlation exists when stock price increases as the local currency depreciates. An example of negative correlation is if the stock price of German pharmaceutical-maker Bayer AG rose with a depreciation of the euro.
Positive correlation - A positive correlation exists when stock price decreases while the local currency depreciates. An example of positive correlation is if the stock price of Toyota were to decrease with a depreciation of the yen.
Using the returns of assets, like stocks and changes in exchange rates for a defined period of time, it is possible to measure currency exposure over a set period.
Correlations can help investors conduct a more comprehensive evaluation of an investment. Suppose an investor forecasts that the euro will decline in value versus a basket of currencies. Weakness in the euro would be beneficial if Bayer AG has a negative correlation. As the euro declined in value, Bayer's stock price would increase.
It is important to realise that correlations are purely empirical observations of the relationship between stock prices and currency exchange rates. Net impact of currency fluctuations can be more complicated. For example, if the U.S. dollar loses value and American restaurant chain McDonald's Corporation has a negative correlation, the stock price may rise. However, oil and other natural resources used in the production process will, in all likelihood, become more expensive. That would have a negative effect on the company's operating performance in the future, and would alter the net result of the currency impact.
The Bottom Line
The relationship between asset returns and exchange rate movements is critical in international asset pricing. Overall currency impact depends on the currency structure of exports, imports and financing. It may be necessary to conduct a more thorough analysis for companies with diverse international operations. This involves assessing the operational activities and financing of a company in each country where they do business.
By understanding the impact on individual companies and assets, and the correlations that exchange rate fluctuations have with asset returns, investors are better able to evaluate the currency exposure of their portfolio.