Managing foreign exchange exposure in your portfolio

The value of investments is significantly affected by changes in global currency exchange rates. Investors should appreciate the influence that the currency market has on the assets they own and their level of currency exposure.

Exposure to transactions and currencies

Exchange rates affect investors around the world. For example, investors in automaker Toyota Motor Corp. (TM) have currency exposure because the company sells cars in countries outside of Japan. Toyota sells cars in the United States for US dollars, in France for euros and in Britain for pounds. After receiving these foreign currencies, Toyota converts the currencies back to the national currency (yen). Changes in exchange rates influence the value of the currency Toyota receives when it is converted back to yen. In turn, investors in Toyota are affected by this activity.

Investors also have currency exposure due to 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 settled. The currency exposure of an asset, such as stocks, is the sensitivity of the return on that asset measured in the investor’s domestic currency to fluctuations in exchange rates.

key findings

  • The value of investments is affected by changes in global currency exchange rates.
  • Investors, as business and asset owners, have currency exposure through exchange rate fluctuations.
  • Foreign exchange influences on a company’s operating performance will affect its stock prices.
  • There are three correlations between stock price performance and exchange rate fluctuations: zero correlation, negative correlation, and positive correlation.

The global influence of Forex

Movements in the real exchange rate can have a significant influence on international economies and corporations. As real exchange rates rise and fall, companies’ profits, costs, margins, and operating incentives change.

As an example, consider the French tire manufacturer Michelin (MGDDF). If the euro appreciates substantially against a variety of currencies, Michelin will be affected in a number of ways.

First, the appreciation of the euro would affect the entire French economy. French products would become more expensive because more foreign exchange is needed to buy francs. Therefore, net exports outside of Europe are likely to decline. Michelin, as an exporter from France, would be selling more expensive products abroad and would likely experience a decrease in total sales. If sales actually fell, Michelin’s profitability would suffer and the share price could fall.

Alternatively, if the franc were to depreciate substantially against a basket of coins, Michelin tires would be competitive in price. Sales would likely increase and Michelin’s profitability would improve. In addition, Michelin could lower its selling price in foreign markets without hurting margins, and there would be incentives to manufacture products in France, where production costs are lower.

Investors should be aware of the impact that the US dollar exchange rate has on all assets. Many commodities, including oil, are priced in dollars. A depreciation of the US dollar generally increases the price of raw materials, while an appreciation of the dollar tends to lower the prices of raw materials. This unique relationship must be taken into account in any currency exposure analysis.

Stock price evolution and exchange rate fluctuations

All of these currency influences on a company’s operating performance will, of course, have a ripple effect on its stock prices. 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 there is no reaction of the share price to changes in exchange rates, there is zero correlation. An example of a zero correlation is if the share price of US electronics producer Apple Inc. (AAPL) remains unchanged as the US dollar falls 1% in value.
  • Negative correlation – There is a negative correlation when the price of a share increases as the local currency depreciates. An example of a negative correlation is if the share price of the German pharmaceutical manufacturer Bayer AG rises with a depreciation of the euro.
  • Positive correlation – There is a positive correlation when the price of a share decreases while the local currency depreciates. An example of a positive correlation is if Toyota’s share price decreased with a depreciation of the yen.

Correlations can help investors make a more complete evaluation of an investment. Suppose an investor expects the value of the euro to decline against a basket of currencies. The weakness of the euro would be beneficial if Bayer AG has a negative correlation. As the value of the euro declines, Bayer’s share price would 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 can be more complicated. For example, if the US dollar loses value and the US restaurant chain McDonald’s Corp. (MCD) has a negative correlation, the stock price may go up. However, the oil and other natural resources used in the production process will likely become more expensive. This would have a negative effect on the operating performance of the company in the future and would alter the net result of the exchange rate impact.

The bottom line

The relationship between asset returns and exchange rate movements is fundamental in the pricing of international assets. The overall monetary impact depends on the monetary structure of exports, imports, and financing. A more in-depth analysis of companies with diverse international operations may be necessary. It is about evaluating the operational and financing activities of a company in each country in which they operate.

Using the returns on assets, such as inventories and changes in exchange rates over a defined period of time, it is possible to measure the currency exposure over a specified period.

By understanding the impact on individual companies and assets and the correlations that exchange rate fluctuations have with asset returns, investors can better assess the currency exposure of their portfolio.

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Mark Holland

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