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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.

Nasdaq OMX Group is a Motley Fool Inside Value recommendation. NYSE Euronext is a Motley Fool Rule Breakers pick. Aflac is a Motley Fool Stock Advisor recommendation. Ituran Location & Control is a Motley Fool Global Gains pick. Motley Fool Options has recommended writing covered calls on Nasdaq OMX Group. The Fool owns shares of Aflac. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Jacob Roche owns call spreads on Aflac, but holds no position on any of the other stocks mentioned. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.

Read/Post Comments (4) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 12, 2010, at 8:36 PM, StockNewb wrote:

    Nice article, so in theory investing directly into a small/mid cap company that operates in a certain country could get a double whammy of growth...... hmmm :P

    To the middle east and asia! off off and away!

  • Report this Comment On October 12, 2010, at 9:05 PM, xetn wrote:

    In fact, almost every country in the world has been trying to drive their currency to near zero in hopes of gaining a competitive advantage in exports. So we have a race to the bottom. The US (with the help of the Fed creating trillions of new dollars out of thin air) has lead the charge, but still think the Chinese are not doing enough to help increase US exports (the Yuan is still too low). So the US is accusing the Chinese of currency manipulation, when in fact so is the US and every other country. The simple solution to the international exchange rate problem is to price all exchanges in gold. But then we would have to compete in cost of labor etc.

    I would prefer to have a very strong currency because I would be able to purchase more. Having a weak currency just increases my costs of everything. And the actions of the US government spending like a drunken sailor and the Fed creating mountains of new dollars is sure to lead to massive amounts of price inflation. As a matter of fact we have had very large price increase in basic commodities in recent months, so inflation has already reared its ugly head.

  • Report this Comment On October 13, 2010, at 6:07 PM, midnightmoney wrote:

    Mcdonald's shares are called Mcshares, according to their drip program. Here's a wholesome article about their food:

  • Report this Comment On August 24, 2011, at 7:53 PM, valetner wrote:

    i worked for this company in miami, from it's think every dog has it's day....i don't want this to sound like some disgruntled employee.....but these guys are ( in israel ) light years ahead of us in terms of getting the most for the least....a small precentage of money is made in u.s., while huge amounts in south america and canada and in israel are funneled thru u.s.....sales outside of a small area in south florida do not exist....there is absolutely no penertration in any area of the ..this is one of the very few companies that during the ecomonic recession and the primary target business is the automative indusry, there stock was driven up...while lojack ( a household name ) dropped ......i guarantee no person reading this has ever heard of lifetrak.....but they have heard of's too bad the i.r.s. is sleeping on this one.......I attended a recent phone quarterly meeting, i wasn't allowed to ask any questions, but some one should just aske them ..HOW MANY UNITS ARE YOU SELLING IN THE big is your marketshare in the u.s........meanwhile these guys are sitting pretty...unaware of any economic downturn.....we have a long way to unravel this one......there motto " our tracking device is sweeping the nation by storm" ........

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