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 issue.

International firms vs international currency

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 less.

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 volatility.

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 really performing.

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 profits.

This is part XIV of a series powered by Saxo Bank’s Modern Wealth Management team.