Will Fluctuations in Foreign Exchange Affect a Company’s Share Price
Even when you invest in shares that are listed on your domestic stock exchange, you may run a foreign exchange currency risk. Further below, you find the three choices that you have when you decide how to face this situation.
First let me describe the problem.
The share price of a company is a reflection of its financial results and growth potential. And this price is nominated in a certain currency. Now what happens when a company generates a major part of its costs or revenues in a foreign currency?
Two Foreign Exchange Impact Examples
Here is an example. Company A is selling the majority of its products in the domestic market. However, Company A is producing most of its products abroad, in a country with a foreign currency. Imagine now that this foreign currency increases in value compared to the domestic currency.
The result is that the costs for Company A are increasing measured in its home currency. And when costs are increasing faster than revenues, earnings are declining. And when earnings are expected to decline, the company’s share price is likely to decline.
Take Company B. This company generates a majority of its business abroad in foreign currencies. Suppose now that those foreign currencies decline in value compared to the home currency.
The result will be that, measured in the home currency, the revenues of the company will decline. And a company with declining revenues may expect its share price to go down as well.
How Companies Handle Fluctuations
Companies do not like the fact that their share price can be impacted a lot by changes in foreign exchange rates. Companies, just like their investors, like a certain level of predictability.
Therefore, often companies use banks to hedge a part of their foreign currency risk. The banks offer these companies products that help them to manage the changes in corporate foreign exchange rates.
However, since this type of insurance against these fluctuations comes at a cost, companies will hedge only a part of their risk, but not all.
Thus as an investor, you are happy that the risk is reduced, but you are also still partly exposed to it when you invest in these companies.
What can you do?
Your Three Choices
Here are three options for how to handle as an investor the possible impact of foreign exchange fluctuations on a company’s share price:
- Invest only in companies that operate domestically. Just remember that this excludes probably most Mid Cap and Large Cap companies from your list.
- Invest in companies with a clear exposure to a certain foreign currency and hedge your risk with currency futures. This approach requires detailed financial analysis of the companies you want to invest in and complex calculations of how large your hedge should be.
- Accept the fact that we live in a global world and that you will face a certain level of currency risk. Diversify your investments over a large group of companies by buying for example S&P 500, FTSE or DAX index funds.
Personally I prefer the last option. Accept that we can’t hide. Most companies are hedging these risks already to a level that is acceptable to them.
If you have any other ideas on this, please share it as a comment below.