Managing Currency Exposure in Your Portfolio

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

Currency and Transaction Exposure

Exchange rates impact investors worldwide. For instance, 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 U.S. dollars, in France for euros, and in Britain for pounds. After receiving these foreign currencies, Toyota converts the currencies back to the domestic currency (yen). Changing exchange rates influence the value of the currency that Toyota receives when it is converted back to yen. In turn, investors in Toyota are impacted by this activity.

Investors also 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 settled. 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.

The Global Influence 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.

As an example, consider the French tire manufacturer Michelin (MGDDF). If the euro appreciates substantially against a variety of currencies, then 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 would improve. Moreover, Michelin could lower its selling price in foreign markets without hurting margins, and there would be incentives to manufacture products in France where the production costs are lower.

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.

Stock Price Performance and Exchange Rate Fluctuations

All these forex influences on a company’s operating performance will, of course, have a knock-on effect on its stock prices. Most investors are impacted by these currency 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 rates, there is zero correlation. An example of zero correlation is if the stock price of the U.S. electronics device producer Apple Inc. (AAPL) does not change while the U.S. dollar falls 1% in value.
• Negative correlation – A negative correlation exists when a stock price increases as the local currency depreciates. An example of negative correlation is if the stock price of German pharmaceutical-maker Bayer AG rises with a depreciation of the euro.
• Positive correlation – A positive correlation exists when a stock price decreases while the local currency depreciates. An example of a positive correlation is if the stock price of Toyota were to decrease with a depreciation of the yen.

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 declines in value, Bayer’s stock price would increase.

It is important to realize those 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 U.S. dollar loses value and the American restaurant chain McDonald’s Corp. (MCD) 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 of companies with diverse international operations. This involves assessing the operational activities and financing of a company in each country where they do business.

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

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.