Manage currency exposure in your portfolio

Investment value is greatly affected by changes in global currency exchange rates. Investors should understand the impact of the foreign exchange market on their assets and currency exposure.

Currency and transaction risk

Exchange rates affect global investors. For example, investors in the automobile manufacturer Toyota Motor Corporation (TM) have currency risk because the company sells cars in countries outside of Japan. Toyota cars are sold in the United States in U.S. dollars, in France in euros, and in the United Kingdom in pounds sterling. After receiving these foreign currencies, Toyota exchanges these currencies back to its domestic currency (Japanese Yen). Changes in the exchange rate will affect the currency value Toyota receives when converting back to Japanese yen. In turn, Toyota investors will also be affected by this activity.

As companies participating in international trade face transaction risks, investors also face currency risks. This is the risk that the currency exchange rate will change after the financial obligation has been settled. The currency exposure of assets (such as stocks) refers to the sensitivity of asset returns measured in the investor’s home currency to exchange rate fluctuations.

Key points

  • Investment value is affected by changes in global currency exchange rates.
  • Investors, as owners of companies and assets, face currency risks due to exchange rate fluctuations.
  • The impact of foreign exchange on the company’s operating performance will affect its stock price.
  • There are three correlations between stock price performance and exchange rate fluctuations: zero correlation, negative correlation and positive correlation.

The global impact of foreign exchange

Changes in the real exchange rate can have a significant impact on the economy and international companies. As the real exchange rate fluctuates, the company’s revenue, costs, profit margins, and operating incentives will also change.

For example, consider the French tire manufacturer Michelin (MGDDF). If the euro appreciates sharply against multiple currencies, then Michelin will be affected in multiple ways.

First, the appreciation of the euro will affect the entire French economy. French goods will become more expensive, because buying francs requires more foreign currency. Therefore, net exports outside Europe may decrease. As a French exporter, Michelin will sell more expensive products overseas, and total sales may decline. If sales do fall, Michelin’s profitability will be compromised and stock prices may fall.

Or, if the franc depreciates significantly against a basket of currencies, Michelin tires will be price-competitive. Sales may increase, and Michelin’s profitability will improve. In addition, Michelin can lower its selling price in foreign markets without compromising profit margins, and will encourage the production of products in France, where production costs are lower.

Investors should pay attention to the impact of the US dollar exchange rate on all assets. Many raw materials, including oil, are priced in U.S. dollars. The depreciation of the U.S. dollar usually increases the prices of raw materials, while the appreciation of the U.S. dollar tends to lower the prices of commodities. This unique relationship should be included in any currency exposure analysis.

Stock price performance and exchange rate fluctuations

Of course, the impact of all these foreign exchanges on the company’s operating performance will have a knock-on effect on its stock price. Most investors are affected by these currency changes through stocks (although other assets, including fixed income, commodities, and alternative assets) are affected 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 the stock price does not respond to exchange rate changes, the correlation is zero. An example of zero correlation is if the stock price of American electronic equipment manufacturer Apple Inc. (AAPL) remains unchanged and the value of the U.S. dollar falls by 1%.
  • Negative correlation -When the depreciation of the local currency causes the stock price to rise, there is a negative correlation. An example of a negative correlation is whether the share price of the German drugmaker Bayer AG has risen in response to the depreciation of the euro.
  • Positive correlation -When the local currency depreciates and the stock price falls, there is a positive correlation. An example of a positive correlation is if Toyota’s stock price drops as the yen depreciates.

Correlation can help investors conduct a more comprehensive assessment of investment. Suppose investors predict that the value of the euro will fall against a basket of currencies. If Bayer AG is negatively correlated, the weak euro will be beneficial. As the euro depreciates, Bayer’s stock price will rise.

It is important to realize that these correlations are purely empirical observations of the relationship between stock prices and currency exchange rates. The net impact of currency fluctuations may be more complicated. For example, if the depreciation of the dollar is negatively correlated with the American restaurant chain McDonald’s (MCD), the stock price may rise. However, the oil and other natural resources used in the production process are likely to become more expensive. This will have a negative impact on the company’s future operating performance and will change the net result of currency impact.

Bottom line

The relationship between asset returns and exchange rate changes is crucial in international asset pricing. The overall currency impact depends on the currency structure of exports, imports, and financing. It may be necessary to conduct a more thorough analysis of companies with different international operations. This involves evaluating a company’s operations and financing in each country where it does business.

Using the return of stocks and other assets and exchange rate changes in a certain period of time, the currency exposure in a certain period of time can be measured.

By understanding the impact on individual companies and assets and the correlation between exchange rate fluctuations and asset returns, investors can better assess the currency exposure of their investment portfolios.

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