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Why you should care about exchange rate risk when you invest

by , 13 October 2014

When you invest, especially in large companies, there's a good chance that some of its revenue comes from overseas.

If this is the case, the company comes with exchange rate risk. This is the risk that an exchange rate will work against the company's revenue streams, hurting the bottom line.

So how can exchange rate risk affect a company?

Let's take a closer look…

Where the risk from an exchange rate comes from

Exchange rate risk comes from big swings in values. Let’s have a look at this with the help of an example…

Let’s say a company in South Africa plans to build a factory in the US. The rand/dollar exchange rate is 11.04. So $1 buys R11.04.

If the exchange rate moves significantly up or down, it can have a big bearing on the South African company. And it will affect the company’s profits.

If the factory costs the company $500 million to complete, that would cost R5.52 billion. But if the rand weakened to 11.30, the bill would rise to R5.65 billion.

This is transactional foreign exchange risk.

This can also have an effect on sales. The rand weakening means the South African company’s product would be cheaper in the US, which could result in higher sales.

How exchange rate risk affects a company’s profits

Profits in rands can also fall if the exchange rate changes. This is translational risk.

For example, $100 million of profits at R11.30 is R1.13 billion. If the rand strengthened to R11.04, the profits would be R1.104 billion.

The company can earn fewer dollars to make the same rand of profit. But if the rand rises in value, the company’s overseas profits fall.

This can have a big bearing on a company’s accounts.

So there you have it, why you should care about exchange rate risk when you invest.

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Why you should care about exchange rate risk when you invest
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