This Threat Could Pound Your Stocks

If you're like most investors, the only time you pay much attention to the value of the dollar against foreign currencies is when you're planning your next vacation abroad. If you ignore how the dollar's moving, however, it could end up costing you a lot more than just the price of a marked-up cup of cafe au lait at a Parisian coffee shop.

Why currencies matter
In today's global economy, foreign exchange rates make a huge deal of difference. Typically, companies that buy and sell products abroad set prices in the local currencies of the markets where they do business. For instance, if you buy a bottle of Sprite in the U.S., you might pay $1.50, while the same bottle might cost one British pound in London. So it becomes vitally important for Coca-Cola (NYSE:KO) to know what that pound is actually worth.

For U.S. companies, the impact of currency fluctuations depends on which direction the dollar is moving. When the dollar strengthens -- meaning that it takes more of a given foreign currency to buy dollars -- then the value of a company's foreign revenues in dollar terms falls, potentially reducing total sales and income. If the dollar weakens, then those foreign revenues become more valuable in dollar terms, boosting sales and helping profits.

Lately, the dollar has been relatively strong, and many U.S. companies have cited the negative effect of currency translations on their bottom lines in their most recent quarterly reports. Here's just a sample:

Source: Company quarterly reports.

How companies respond
Although foreign exchange rates move independently and sometimes fluctuate violently over short periods of time, companies aren't entirely helpless. They have a number of choices to try to lessen the impact of adverse currency movements:

• They can raise the price of the products they sell in foreign-currency terms to make up for the dollar's rise. However, the presence of local competitors usually constrains a company's ability to raise prices without losing business, hurting gross revenue and market share.
• They can hedge against currency movements using currency futures and other foreign-exchange derivatives. To do so effectively, though, they must accurately predict how much foreign revenue they're likely to generate, in addition to the movement of the dollar. If they're wrong, then their hedges can actually work against them.

These methods aren't perfect, but they can ease the sting of a stronger dollar.

How you can profit from a stronger dollar
Luckily, it's easier for investors to protect themselves from currency movements. Although a stronger dollar hurts U.S. companies that sell their products abroad, the accompanying weakness in foreign currencies gives foreign companies that sell their products in the U.S. a corresponding boost.

For instance, Japanese automakers like Honda and Toyota love to see a stronger dollar, because it boosts the value of their revenues in Japanese-yen terms. A weaker dollar, on the other hand, forces them either to accept lower yen-based profits or to increase prices, potentially cutting demand and yielding ground to U.S. competitors.

The dollar's movements can have a big impact on your stock portfolio. If you want to protect yourself against currency fluctuations, the easiest way is to make sure you have part of your money invested in international stocks. That way, while some companies in your portfolio may suffer, others will certainly benefit. The profits you earn should prove to be enough that you won't have to spend time on your next vacation worrying about how much that Parisian coffee shop is really charging you.

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