Methodology

Stocks

Module 3

Currency Risk

Currency risk happens when the value of a currency changes in relation to another currency. It can impact investors or companies that do business in other countries.

For example, if $1 is equal to £0.70 and a British company imports products worth $100 in pounds, they would pay £70. However, if the pound weakens to £0.80 for $1, then all of a sudden the company would be paying £80 for products that would have previously cost just £70.

Although this example may seem like quite a minor change, when you consider that companies usually buy and sell millions of products every year, it can have a huge impact on their earnings. This change could have a significantly  negative impact on their share price.

Of course, it is important to say that the opposite could happen and that the local currency of a business becomes more valuable than the currency that they do business in. This would reduce the expenses of the business and boost profits, increasing the share price.

It is not only the process of buying and selling products that expose a company to currency risk. It is common for companies to borrow money in other countries, which means that currency risk can increase or decrease the amount of interest that they pay on their interest payments in their local currency.

For instance, if $1 is equal to £0.70, with a British company paying $1000 in interest on a monthly using pounds, they would pay just £700. Likewise, if $1 turns into £0.80, then the interest payment would become £800 a month. Much as with before, this increased cost can reduce earnings and push down the value of the stock of the company. 

So, if you ever consider borrowing money in another country, bare this situation in mind. Currency changes may mean that debt borrowed in other countries becomes completely unaffordable.

Currency risk and investors

Currency risk can have a significant impact on investors as it can reduce the returns that they make. 

If an investors makes investments in foreign stock markets, the return that they earn will depend on the performance of the stocks, as well as the relationship between the value of their home currency compared with the currency used in the foreign stock market.

Much like with businesses, this can be a positive thing for an investor if their home currency weakens, meaning that they earn a higher return. On the other hand, it can be a negative thing if the opposite happens.

Currency risk can impact the return that an investor earns, even if they only invest in local companies. This is because local companies tend to import products or materials from overseas, meaning that their profit will be influenced by how much they spend on those purchases. 

It can also be the case that the local companies benefit from the weakening of their local currency, as it makes products cheaper for customers from other countries to buy.

A good example would be with Brexit, where going on holiday in the UK became a lot cheaper for people from other countries, resulting in increased tourism. This benefited local tourism businesses, like small hotels or resorts, who made larger profits as a result. 

So, currency risk can have a positive or negative effect on investors, depending on what currencies, sectors and types of companies that they invest in.

Reducing currency risk

In terms of reducing the amount of currency risk that an investor encounters, diversification is the key. Investing in a range of domestic, international, large and small businesses will help to reduce exposure to currency risk.

The amount of currency risk that a company endures depends on how many countries that they operate in. The more countries that a company operates in, the lower the amount of currency risk that they are exposed to.

This is the case as the company would deal in a large number of currencies, which means that they are able to hedge against the currency risks that are associated with a particular currency.

Companies will do that by managing the way that they organise their finances in each country. For instance, if a company is waiting to receive a large payment from a customer that is in a currency that has high risk of decreasing in value, then a company may decide to take out a loan in that country and immediately transfer the funds into their home currency. Then, once the customer pays, the company will use it to pay off the debt.

This method reduces the exposure of a company to the currency risk posed by the deal and is a method that is commonly done by large companies that operate in various countries.

Therefore, investors can reduce their currency risk by investing in large companies that operate in multiple countries.

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