In the global financial marketplace, a company can maintain its books in one currency, answer to the interests of stockholders whose equity securities are valued in a second currency, issue bonds denominated in two or more other currencies, and maintain material business operations in currencies other than any of the preceding.
To see the complexity, consider Nestlé S.A. as a prototype. It is headquartered in Switzerland, so the base currency of its group financial statements is the Swiss franc. However, according to company reports, its entire European zone of operations accounted for only about one-quarter of its total revenue, while a little less than one-third came from Asia, Africa, and the countries of the Pacific Rim and just about half came from North and South America.
Moreover, as maker of many well-known consumer products in the United States, the company attracts a significant following among U.S. investors so it sponsors an ADR (American Depositary Receipt) program for trading its shares in the United States. That compels Nestlé to create parallel financial reports translated from Swiss francs into U.S. dollars. And for bond investors, Nestlé has issued significant amounts of debt traded around the world. Various portions of this debt are denominated in Swiss francs, euros, U.S. dollars, Australian dollars, and Norwegian krone.
Currency markets are an integral part of performance
A globally diverse company typically conducts material volumes of routine business in dozens of currencies throughout the year. As a result, its business operations and balance sheet may be subject to significant currency market effects, and these could have strong influences on performance.
For example, from 1971 to 2013, the daily average year-on-year change in the value of the U.S. dollar relative to the Canadian dollar was a small fraction of 1%. But there were one-year periods where there were substantial swings up and down. Moreover, the standard deviation of the values is many times the average value. Standard deviation measures the amount of dispersion seen among the individual one-year results. A relatively large standard deviation implies that the chance of randomly finding average or near-average results in any particular one-year period is relatively small. The table below shows the statistics for a select number of major U.S. trading partners as well as the Federal Reserve’s index of aggregated currency performance against all major U.S. trading partners.
|Federal Reserve Major Currency Index||Euro||Canadian Dollar||Japanese Yen||Mexican Peso|
|Rolling Average of All Potential Year-on-Year Changes||-.40%||1.98%||.22%||-2.22%||8.57%|
|Largest One-Year Decline||-23%||-21%||-20%||-37%||-16%|
|Largest One-Year Increase||24%||27%||33%||33%||134%|
Source: The Federal Reserve Board H.10 historical foreign exchange report for each currency, retrieved from http://www.federalreserve.gov/releases/h10/hist/ on November 18, 2013. All data series end on October 31, 2013, and cover the longest time frames available. The Canadian dollar and Japanese yen daily data series began on January 4, 1971, Major Currency Index daily data series on January 4, 1973, Mexican peso daily data series on November 8, 1993, and Euro daily data series on January 4, 1999. Reported daily exchange values are considered representative of transactions occurring on that date, but any specific transaction may have produced different results. Past performance is not a guarantee of future results. Investors cannot invest directly in any index.
How currency changes can impact a company’s reported financial performance
The details of every company’s accounting practices are determined by law and company policy, and each company faces unique individual circumstances. But multicurrency business dealings are subject to common forces. Financial statements to shareholders are generally compiled in the currency of the country where the corporation is domiciled and its shares have their primary listing.
Assets and liabilities on the balance sheet that are not denominated in the home currency are typically translated into home-currency values using a specified exchange rate. Asset purchases and sales not denominated in the home currency are typically translated at the exchange rates prevailing at the time of the transaction.
Year-to-year changes in foreign currency-based balance sheet values reflect both changes in the underlying asset/liability and changes in the exchange rate used for the translation. Gains or losses attributable to currency moves may be disclosed separately. If not, you can estimate underlying changes by translating each value in a time series back into its local currency using prevailing exchange rates for its period.
International operations are generally conducted in local currencies, with net operating results consolidated into the base currency periodically. As with assets and liabilities, the translated net operating results may reflect both operationally based and exchange rate-based changes.
Major foreign companies that list their shares in the United States through ADRs generally translate their foreign currency statements into U.S. dollars using an exchange rate prevailing at the time of the statement. A U.S. investor evaluating currency effects would have to first consider the translation effects into the base currency of the foreign company, and then the added effects of translation from that base currency into U.S. dollars.
Currency considerations for fixed income investors
Investments in bonds denominated in foreign currencies pose complex accounting and performance issues for their holders. For a U.S. investor, the effective interest payments and principal values from a foreign currency-denominated bond can be reduced if that currency weakens against the U.S. dollar. That would lower the value of future interest payments and redemption amounts when translated back into dollars. Conversely, the net U.S. dollar returns from any particular foreign bond could be enhanced if that bond’s base currency strengthens.
As noted, currency changes over time are commonly significant, so their effects on global investment performance can be material. Understanding how those changes might impact your investment scenarios is a first step toward understanding your exposure to global currency risk and to effective strategies for diversifying it.