Most investors will be familiar with the concept of currency
exposure, with constantly changing exchange rates affecting the
cost of investing in international stocks. These same issues also
affect companies that operate internationally. So what effect do
currency fluctuations have on company profits, and what are they
doing to insulate themselves? In this extract from the
Modern Wealth Management blog, we take a look at this
International firms vs international
Companies with overseas branches, or those that trade
internationally, are at the mercy of global currency fluctuations.
As is the case with private investments, changes in conversion
rates can wipe out profits or increase gains.
When a firm has shareholders to report to, and the figures can
run into millions, then it can have a serious impact on profits and
losses. The rapidly changing currency landscape can have the
potential to make businesses reluctant to set firm figures in
contracts months before a deal takes place. If a US-based firm
makes EUR 10 million, they can end up with much more or less than
they thought depending on the movement of the EUR/USD exchange
rate. For example, in June 2011 it would have been worth $14.4
million, but in June 2012 it would have been worth $2 million
These issues also exist when discussing contracts with
international clients. Although something may seem like a good deal
when it is first written down, it can turn bad a few months later
when the contract is fulfilled.
A study by SunGard Data Systems polled 275 US businesses of
various sizes. It found that 59 per cent of those surveyed had seen
a loss or gain of more than five per cent as a result of currency
fluctuations in the previous year.
"The majority of corporations are in the business of doing
business, producing and manufacturing, not hedging currencies,"
said Paul Bramwell, a senior vice president of Treasury solutions
at the AvantGard unit of SunGard. "A lot of companies were caught
unawares by volatility."
He explained that looking at where the exposure lies instead of
waiting for quarterly results to discover the impact of
fluctuations was a better approach, although he conceded that this
is a stance more and more firms are taking.
The impact on real businesses
Therefore, organisations have to evaluate the risks of doing
business on an international level. But it doesn't always work in
their favour. For instance, McDonald's saw sales in Europe increase
in 2011, but the yearly profits were actually down as a result of a
weakening euro. Indeed, some experts think investors should be
cautious this year too given that the US dollar has strengthened so
much recently and is expected to continue doing so. As McDonald's
generate nearly three quarters of its profits overseas, this could
be an issue if they have not hedged.
Another recent example of this happened at eBay, with CFO Bob
Swan admitting that currency fluctuations will hit the bottom line
by around three points in 2012. Ralph Lauren reported that although
currency changes have gone in its favour so far in 2012, it expects
a turnaround in fortunes in 2013.
"Foreign currency effects are estimated to negatively impact net
revenue growth by approximately 200-300 basis points in the first
quarter," the company stated.
What can firms do?
As with private investors, business essentially have four
options to counteract their currency exposure.
The simplest approach is just to monitor the changes, and this
can be the best option if companies do not think that they are at a
particularly high risk from exchange rate fluctuations.
Another option is to lock into an exchange rate for a fixed
period of time by setting up a forward contract. If the exposure
estimates are correct, this can be a beneficial approach. Some
businesses will also purchase currency in advance if they know that
they will be making big purchases and are concerned about
A third option is to hedge against this exposure via
derivatives. Although this may be the most complicated option, it
can be effective in limiting exposure to volatility. It can also
give a clearer picture of how a company's overseas operations are
Finally, firms can choose to manage their currency exposure
through business practices. Having a truly international company
can help with this as, theoretically, losses made when one currency
falls will be recovered when another rises. Where contracts are
concerned businesses can also set up clauses that reduce this
exposure. In many cases this comes in the form of an agreement to
protect the client and the company should exchange rate movements
exceed the agreed-upon level. Some businesses also agree on setting
all contracts in their core currency, protecting them from any
exposure as they will always be paid the same relative amount.
Dealing with currency exposure is all about managing risk, as
fluctuations are by their very nature unpredictable. However, while
private investors only have their own savings to worry about if
they fail to manage this risk appropriately, businesses face angry
shareholders and a drop in share value - as well as a drop in
This is part XIV of a series powered by Saxo Bank's Modern
Wealth Management team.
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