Most people aren't quite sure how the global foreign exchange market works, or how exchange rates matter beyond making a vacation more or less expensive. But in truth, the foreign exchange market (forex for short) is the biggest market in the world, absolutely dwarfing more familiar stock markets.
So far in 2010, about $50 billion was traded daily on the Nasdaq exchange, whereas $4 trillion is estimated to trade daily in the foreign exchange market. The two biggest U.S. stock exchanges are owned by Nasdaq OMX (NYSE: NDAQ ) and NYSE Euronext (NYSE: NYX ) , but the forex market is so big that no one owns an exchange to contain it.
Everyone from tourists to multinational corporations to central banks uses forex to do business and maintain stability. But what makes one currency rise or fall against another, and why does it matter to an individual stock investor?
The United States of America (Ticker: USA)
In the simplest terms, a currency is like a country's stock ticker. If you want to invest in McDonald's (NYSE: MCD ) , you exchange dollars for shares of MCD. If you want to invest in the United Kingdom, you exchange those dollars for pounds. If a country is growing, and selling more goods to the world than it is importing, its currency should strengthen, just as a stock ticker would. You may have heard your politicians recently accuse China of artificially keeping its currency, the yuan, low against the dollar. They claim that if the market were able to value the yuan properly, it would rise substantially against the dollar, because of America's large trade deficit and China's vast trade surplus.
The currency world presents interesting opportunities for companies. McDonald's, for example, recently issued about $29.5 million in yuan-denominated bonds. This might seem odd, because if the yuan is ever allowed to appreciate, those bonds would become more expensive to pay off in dollar terms. However, borrowing yuan now allows McDonald's to finance its growing Chinese operations without worrying about short-term currency fluctuations. By the time the yuan is allowed to appreciate (if ever), McDonald's will likely have been able to build up sufficient Chinese operations to take full advantage of the currency's newfound strength.
When dollars just won't do
Other companies make a much greater bet on the success of one country versus another. Aflac (NYSE: AFL ) , for example, takes in about 70% of its revenue from its Aflac Japan unit, and the rest from Aflac U.S., where the company is incorporated. Because the company ultimately reports its earnings in dollars, changes in the dollar-yen exchange rate could have a significant impact on reported earnings, whether or not the underlying business has seen any change.
However, Aflac uses several different hedging methods to reduce its currency risk. Some of these are very complicated, but others simply involve issuing yen-denominated debt and investing in yen-denominated assets. Even still, in 2009, the yen-dollar exchange rate had roughly a 4% impact on operating earnings, pushing earnings up $55 million.
Israel-based Ituran (NYSE: ITRN ) has an even more complicated structure. The company has two business segments, "location-based services" and "wireless communications products." The latter collects most of its revenue in Israeli shekels, but purchases its inventory mainly in U.S. dollars. Meanwhile, the location-based services segment does roughly half its business in Israel, but the other half in Brazil, so its revenue is split mainly between shekels and Brazilian reals. Similarly, about half of Ituran's employees are based in Israel, and the other half mainly in Brazil, and all are paid in local currencies. To top it all off, Ituran's stock has an ADR, and thus must submit a Form 20-F with business results reported in U.S. dollars.
Ituran does some currency hedging, but its most recent Form 20-F is fraught with large growth in both revenue and expenses, "mainly due to revaluation of the NIS and Brazilian Reals against the US Dollar." While many companies do business in emerging markets such as Brazil to benefit from their growing economies, Ituran is going a step further. It's making an implicit bet on Brazil's currency as well, bringing in mostly unhedged, real-denominated revenue, and reporting it in dollars. While that strategy is working, Ituran is essentially the LoJack (Nasdaq: LOJN ) of Israel. It's not in the currency-trading business, and juicing its results with strengthening currencies clouds the performance results of its actual operations.
A heated exchange
The world is not that big of a place, and it's getting increasingly hard to find a company of any real size that doesn't do any kind of foreign business. Except as a matter of politics or vacation-planning, though, currency exchange rates don't seem to get much discussion.
When you do due diligence, it's important to investigate why a company is exposed to a certain currency, and how the company deals with that risk. Make sure you know whether they use hedging instruments to negate most of the effects of currency fluctuations, or whether they leave their currency risk mostly naked, making material profits or losses on something that has little to do with the underlying business.