Currency Risk
Thursday, September 9, 2010 at 12:36PM How Does Currency Risk Affect an Investor’s Perspective?
by Chris Marchalleck
When volatility dominates our currency markets, investors and analysts alike are suddenly confronted with currency risk issues that are very difficult to assess since very little evidence exists to support any attempt at measurement. Financial news pundits are the first to lament this lack of material information, especially during the recent debt crisis in Europe. News hosts contemplated the fate of large multinational corporations and the downside risk that earnings might fall precipitously. These discussions may have raised viewer ratings, but they had little to do with the actual impacts of currency risk on corporate earning statements or on the respective shareholders of the firm’s stock.
Currency risk, as defined by a popular Internet glossary, “is the possibility that currency depreciation will negatively affect the value of one's assets, investments, and their related interest and dividend payment streams, especially those securities denominated in foreign currency.” This definition suggests that three different parties might be impacted, those being the corporation, its domestic shareholders, and parties in foreign countries that own the securities that are denominated in a currency other than their local currency. The perspective of each group varies based on a number of factors that all students of investment principles should be aware of and understand.
For corporations of any significant size, the firm’s Treasury Policy mandates the mitigation of near-term currency risk. Corporate treasurers must assess their company’s risk exposure, develop a strategy to minimize that exposure, and then implement and review on an ongoing basis the appropriate strategy. U.S. corporations tend to contract in U.S. Dollars to fix the value of revenue or for purchases, especially when importing from China and other developing nations. The degree that currency fluctuations may impact the importation of other manufacturing inputs is then assessed. Hedging strategies are employed either by buying forex forwards to match expected payments or by using forex options to fix downside risk and allow for upside potential gains.
For these reasons alone, corporate earnings for the near-term were fairly well insulated from the severe decline of the Euro in 2010. Since its introduction, the Euro has hit a high of $1.60 and a low of $0.82, but has now settled around the midpoint of these two figures. Corporate treasurers have been successful in managing these swings in value through the hedging techniques discussed above. However, corporate executives worry more about the longer-term aspects of currency swings. A stronger Dollar can translate to a reduced appetite for U.S. exports and may actually support the ability of a competitor to gain a market share advantage through price competition.
For the individual investor in the United States that owns stock in an S&P 500 company that has global operations and sales, he can take some comfort in the fact that hedging practices will most likely protect his dividend and stock valuation potential. However, a wise investor is always looking for growth opportunities that may increase a stock’s value at well above industry averages. Multinationals tend to homogenize global growth characteristics due to their global footprint in many markets. Searching for trends in today’s global marketplace has determined that developing countries are growing at twice the pace of developed country economies.
How might an American investor take advantage of this trend? There are three preferred methods, assuming that having a trade account in another market is out of the question. An investor can buy an American Depository Receipt, and ADR, which is “a negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange.” It is denominated in Dollars, such that all income items are reportable in Dollars, but it does not necessarily insulate the investor from currency or economic risk. Investors can also invest in mutual funds or Exchange-Traded Funds, or ETFs, which specifically focus on holding international securities in their portfolios. The funds will report everything in Dollars, and the risk exposure will resemble an ADR, but diversification of risk will be the ultimate benefit of these two investment vehicles.
Lastly, we have the foreign investor that wishes to invest in U.S. companies. They, too, have similar options related to ADR-like instruments, mutual funds, or ETFs. However, as with their “cousins” in the United States, their earnings will be subject to currency risk during the translation of income back to their home country. If the risk is assessed to be material, then a hedging strategy involving forex options might be appropriate.
While globalization has created many new growth opportunities for corporations, investors must also confront the issue of currency risk if they wish to benefit from these various company strategies. Forex options offer a convenient way to hedge a portion of this exposure in the near-term.
About the Author: Chris Marchalleck attended college in Florida where he studied micro and macro economics. He currently works as a market analyst for forex traders, an online resource for the foreign exchange market.
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Reader Comments (18)
sir
i really liked your blog.
could you explain me about corporate hedging?
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