Updated: Sep 23
In 2016 almost 30% of U.S.-based companies reported an average decrease of $0.04 per share due to foreign currency fluctuations. For many of these companies, a decrease of that scale would lead to missing investors’ earnings expectations. When earnings expectations aren’t met, companies may find it difficult to attract additional investor funding.2 Consequently, it is important to understand how businesses are exposed to foreign currency risk, whether through transactional and translational changes or through credit and liquidity issues3, so that companies can proactively manage that risk.
Types of Exposure
The Euro to U.S. Dollar exchange rate increased from .87 to .92 between January 2019 and September 2019.4 Although it is hard to know exactly why exchange rates fluctuate, contrasting economic and political factors, like trade agreements and differing inflation rates, are often the cause.5 Thus, stable economies tend to hold exchange rates fairly constant. However, even the smallest changes can have a large impact on a business. Here are a few examples that illustrate how various business components can be impacted by foreign currency exchanges:
For fiscal 2019, Apple’s net foreign currency translations resulted in a loss of $408 million.6 Microsoft reported similar numbers, as did many other companies with foreign subsidiaries.7 These translation adjustments are a result of converting the financial statements of a business component or investment that operates in a different currency (functional currency) into the currency of the parent (reporting currency). Because different aspects of the financial statements will use different exchange rates–assets and liabilities will typically use year-end rates while income statement accounts use the yearly average—companies are often left with large foreign currency translations to account for.
Similarly, trading shares in a foreign currency can cause unpredictable gains and losses for a business. For example, purchasing 10 shares for €100 in January 2019, and selling them for €102 in September 2019 would have produced a loss of $41, or 4.1%, (using the previously discussed exchange rates) when most people would have expected a gain of $20, or 2%.
Purchasing materials, goods, or services from a company in a different currency may increase or decrease the costs associated with acquiring those products. Walmart, the company with the largest volume of imports in the U.S.8, reports foreign exchange risk as a major factor when forecasting financial statements and analyzing areas of improvement for the company.
Although Walmart actively hedges against exchange risk volatility, the company reported foreign exchange losses of about $2.1 billion in 2018.9 For Walmart, and other importing businesses, this foreign exchange impact will be reflected in inventory and cost of goods sold balances, various ratios, and eventually the price at which a company can sell goods. If the exchange rates don’t move favorably, customers may find themselves bearing the burden of higher import costs.
Dave Pierce, the managing director of global hedging products at GPS Capital Markets Inc., told a story on the InternationalHub Cultural Conversations podcast about a U.S. Company that lost millions because of foreign currency fluctuations. This company was selling its products to a distributer in Mexico when, basically overnight, the Mexican peso devalued by about 50%. And so how much money the distributer owed this US company doubled in [terms of] Mexican Pesos. So, what did the company… in Mexico do? They just didn’t pay the bill. And that was $16 million dollars this company was out of pocket because their supplier… in Mexico just decided not to pay it.10
Although most companies will not face situations this extreme, foreign currency fluctuations often cause stress between companies and those they export to.
Supply and Demand
Domestic companies with no foreign investments will have some risk associated with changing currency rates. These risks often arise from economic changes, increases or decreases to supplier prices because of the supplier’s own foreign currency exposure, or increases or decreases to purchase prices because of the impact on competitors. Thus, no company is immune to foreign currency exchange risk.
Many techniques exist to help alleviate the risk that companies are exposed to.
Foreign Currency Accounts
Companies who frequently deal with a particular foreign currency may find it beneficial to hold a certain amount of that currency in a separate account. This will remove gains or losses that would have been recognized on each transaction and simply include a translation adjustment of the cash balance at the end of each reporting period.11 Walmart does this by issuing and holding long-term debt in certain foreign currencies.12
Hedging Through Financial Instruments
Many financial instruments exist for hedging foreign currency exposure. In the US, companies typically use Forward Contracts, as local regulations favor the conservative nature of those instruments.13 However, cultural tendencies and regulatory differences, like gambling and risk seeking or using a different set of accounting standards, often lead to less conservative standards in other countries. Thus, for companies operating outside of the United States, foreign exchange options are more widely used. Apple uses both forward contracts and options, depending on availability and need.14
Many consulting companies have surfaced that help businesses budget and manage foreign exchange risk. One such company is GPS Capital Markets, the company mentioned previously in this article. Using a company that specializes in managing foreign exchange risk is beneficial when a company is new to the concept of hedging and has significant exposure to foreign markets.
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