It pays for ordinary investors to understand them so they can look for these in a company’s filings and choose the right investments for their risk profile.
Assets and liabilities
Companies try to hedge against fluctuations in currency rates by locking in exchange rates to avoid an unexpected increase in their liabilities or debt.
An American company looking to expand overseas might borrow a loan denominated in US dollars. If, say, the revenue earned from the venture is in Swedish krona and the exchange rate collapses because the value of the krona falls, the company still has to maintain its loan repayment in US dollars. A 50% decrease in that local currency’s value turns a $100 million payment into a $200 million obligation.
“The payment skyrockets if it’s not hedged,” said Rimkus. “Eventually, a company will be forced to deal with the change in the price. Hedging simply buys them time to adjust their operations, product pricing, raw material sourcing, shipping (and) manufacturing strategy.”
If exchange rates move in the other direction, the company’s investment in Sweden just got cheaper.
Revenues and expenses
When revenues are collected and expenses are paid in different currencies, a stronger US dollar presents a different sort of problem.
“If the expenses are in euros and the product is sold in US dollars, the profit margin could get squeezed by a loss because of exchange rates,” Rimkus said.
Look to see if companies you invest in use one of these revenue and expense hedging strategies.
Companies use different strategies to minimize profit margin squeeze. Among them: actively hedging cash flow by using forward contracts to lock in exchange rates or avoiding the mismatch by keeping expenses and revenues for an operation in the same currency.