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
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
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
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.
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
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.