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Foreign Exchange issues - an important consideration when investing

Over the past few months, investors have been witnessing volatility in foreign exchange markets, primarily brought about political instability, in addition to economic shortcomings.

There are two sides to this issue. The first is the risk of financial contagion. Contagion is extremely subjective and therefore, hard to project. A few things increase systemic risk, from reaction loops to leverage, but overall few reliable predictions can be made on border cases such as the lira.

A more "concrete" matter is the effect of foreign exchange price movements on the individual microeconomics of a business.

So when it comes to dealing with Forex, there are, amongst others, three simple questions to ask: is the currency problem translational or transactional?

Translational means that the currency move simply alters your reported profit, but the fundamental economics stay intact. Transactional means that the currency move impacts your costs, but not your revenues or vice-versa. Thus, it alters the fundamental economics of your business.

Both are actual risks, but transactional risk is of much greater importance than translational.

If you have income in one currency, but expenses in another, then you can have a mismatched cost and debt structure - transactional risk. On the other hand, if you have matched income and expenses, but you report in a third currency, then your operations will function well, but the reported bottom-line in your home currency might be distorted.

Is the currency problem material?

On the whole, translational problems will not be material unless there is an extremely heavy debt load reliant on cash flow generation.

Transactional problems are substantial in a wide range of outcomes including, but not limited to:

Entire output/input mismatched

Forex issues persist across the cost structure. Imagine an oil rig that sells all their oil in dollar-denominated markets, but pays all the workers and buys all the machines with another floating currency. Any currency move will impact the entirety of the business model.

This is commonly seen with niche companies that export from minor countries to global giants.

Financing issues

Issues where the company has financing in US dollars, but income and costs are in another currency which leads to funding issues. It is important to check the debt-type and schedule of the bonds. Bullet-type loans can be especially deadly in relation to rapid currency moves if the company is not well hedged.

FIFO/LIFO accounting issues

Imagine that you buy two cars for $150,000 each from an American company. Then those cars are sold to customers who live in Germany for euro. If the cars are sold when the dollar appreciated then a solid profit would be locked in. Had the dollar depreciated, money would be lost.

If a company uses LIFO (last-in-first-out) accounting, the financial statements instantly show the loss made when the dollar depreciated. However, if FIFO-accounting (first-in-first-out) is used, then the statements would show a profit.

When not to care as much?

If a business only has a few minor divisions where the impact is transactional on a back-office level, then the effect would be minimal.

As well as when a business has a clean balance sheet and an ability to diversify their cost structure over time, obviously that one is aware of or than can be made aware of.

Does the company require access to capital markets?

Consider a mine that operates in South Africa and pays all workers in rand and has borrowed heavily in rand. It requires funding again next year but sells copper for dollars on the international market.

If the dollar depreciates, income will decrease while costs remain stable. In other words, the mine will lose profitability. The current debt also becomes harder to service. As both of these become true at the same time, the company will have an extremely hard time raising capital at "fair" interest rates.

Furthermore, rapid inflation or depreciation all serve as risk indicators for wary bankers (who are wary for good reason, given the immense leverage inherent in banking).

The bottom line is that a company that needs access to capital markets cannot have a risky business model when related to foreign exchange risk.

Conclusion

These are a few key questions readers should ask themselves when looking at companies with substantial foreign exchange headwinds; there are more.

It can be hard to outline which foreign exchange risk could impact most but in the cases outlined above, it could be argued that the risks are definitely material.
Foreign currency is volatile and hence, investors should be and remain wary. So it is imperative that when investors are doing their bond picking exercise, they identified the possible impact of FX moves versus primarily their debt structure.

Disclaimer:

This article was issued by Maria Fenech, Investment Manager Support Officer at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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