Sun 13 Oct 2024 03:04GMT
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If the Great British Pound
gets weaker against a foreign currency, a company's assets in that
particular currency (for example foreign currency bank deposits or investments)
become increasingly valuable in terms of their GBP value. However, the
liabilities become more onerous in that any loans or borrowings they
have taken out in that currency, become more expensive but sales are
worth more in GBP. Obviously the opposite will be the case should the
pound strengthen against another currency.
Companies will typically look to
reduce their exposure to exchange rate changes. For example, if a company
loaned $1million (United States Dollars) at a time when the exchange
rate was USD/GBP 0.625, it will have been worth £625,000. However,
when it comes to repaying the loan, the rate is 0.650 meaning it is
worth £650,000. The company has therefore realised a loss of £25,000,
Obviously this will be a big concern for the company treasurer not least
because having to find £650,000 to buy the dollars in order to repay
the loan upsets the company cashflow forecasts. Similarly, if they had
budgeted £640,000 to repay the loan and exchange rates change in the
opposite direction, they may only need to pay £600,000.
It is not just realised foreign exchange
profits and losses that international companies have to worry about.
For example the company borrows $1millon USD for five years. From an
accounting perspective, at the end of each accounting period, the loan
will be converted into sterling at the current rate at the last day
of the accounting period. So the accounts of the company will display
an unrealised exchange gain or loss - a loss in one year (when the pound
weakens against the dollar) may still lead to a profit in the next (during
which time the pound has strengthened against the dollar). Some companies
may see such unrealised gains and losses as distorting their financial
records. For this reason, the vast majority of large companies and a
lot of smaller companies that have currency exposure will often look
to hedge this exposure.
The most frequently used way of doing
this is for a company looking to purchase a foreign currency based asset
or acquiring foreign currency investments, to borrow in the same or
a related foreign currency. For example, a company may put $2million
Canadian Dollars in the form of equity into a Canadian subsidiary, borrowing
$2million Canadian dollars from the bank in order to do so. If the Canadian
dollar was to get weaker against the pound, the company's shares in
the Canadian company will decrease in pound value however this will
be offset by a corresponding exchange gain on the borrowing.
In some cases, the foreign currency
borrowing is used to finance the purchase of the asset or the investment
- as in the above example - but a company may equally well borrow in
a foreign currency to hedge an existing investment. And the borrowing
does not always need to be in the same currency to provide an effective
hedge. For example, a UK company may own Swiss franc denominated shares
in a Swiss holding company whose principal asset is shares in a Japanese
company. It might be appropriate for the company to hedge its investment
by borrowing in Japanese yen instead of (or as well as) borrowing in
Swiss francs.
« Exchange Rates - What are they and how are they calculated?
Effect of exchange rates on the value of assets and liabilities »