Forex trading risk: effect of forex on stock prices

In this article, I will cover the topics like
• how forex rates affect the business of a company
• how force rates effect the economy of a country
• how much risk is there in a business involving forex transactions,
• the risks in forex trading, and in general,
• What an investor should look for while investing in companies having significant dependency on forex

All of us know that it is impossible for any bluechip, mid cap and sometimes even a small cap company to remain shielded from a forex rate change. Not only the IT companies biggies like Infosys, TCS, etc. have significant dependency on forex rates, mid and small level companies also depend on it significantly, though indirectly. For example, a small penny stock like Pentasoft Technologies may be getting contracts from biggies like TCS. So if the work of TCS is affected due to forex rate changes, the billing amount will change and so will the income and earnings of Pentasoft Technologies will be affected. Not only in IT, any export driven industry like textile, leather, etc. will also have significant dependency on forex rates. Also, companies that do not necessarily export, but have significant presence in foreign countries may also be affected. For example, reliance may have refineries in Sudan, Tata Steel after buying Corus is now having major stake on Euro and so on. Ultimately, directly or indirectly, the entire economy is dependent on forex rates.

It’s always better to take an example, which automatically answers many questions. I’m sure many of you might have heard of Freddie Laker. Freddie Laker was the pioneer in coming up with the concept of “No-frill” Airlines, or cheap airline travel without many facilities. If today you can see many no-frill airlines like EasyJet, Ryan Air, Deccan Airlines, etc., which made the air travel accessible to common man, it was Freddie Laker who first came up with this concept, that too between long distance countries UK and the US.

Laker started SkyTrain, a no frill airline that was supposed to fly between the 2 big cities, London in UK and New York in the USA. It was the very first and innovative transatlantic venture, which was supposed to revolutionize the airline industry with the concept of no frill cheap air-tickets, making it affordable to the common man.

So it all began with a big hype. It took years for Laker to get government approval and finally he started off with his first flight in 1977. The way it was supposed to work was as follows:

In the 1970’s the Great British Pound (GBP) to US Dollars (USD) forex rate was low. That meant high value of GBP to that of USD, so for UK tourists planning to visit US, it was cheaper. Hence, there were many tourists from UK who would visit US and SkyTrain targeted these tourists. Moreover, Laker started with 1 aircraft and looking at the great response he got from the tourists, he later purchased 5 more airplanes to expand his business.

The only problem was that these airplanes were purchased on lease and were financed in US dollars.

Everything was going quite well for few years. Somehow, in 1982 –within less than 5 years, the Skytrain Company got bankrupt. Why?

The reason was faulty and costly assumptions that were made.

The business had major dependency on forex rate GBP-USD. It was assumed to remain low or go down further. Instead, contrary to the assumption, it increased. Once the GBP-USD forex rate increased, there were fewer tourists to USA - Simply because it was becoming unaffordable for UK people to pay for high expenses in US. Hence, the no. of tourists travelling from UK to US reduced significantly and the earnings of Skytrain was hit significantly.

But it was not all. It was double-trouble. On the liability side, the Skytrain Company had a major setback. Since the aircrafts used by the airline were taken on lease, and that too in USD loan, it became costly to repay the same amount of money because of the GBP-USD forex rate change.

Hence, the trouble compounded. Less Income in GBP, more repayments in USD. Finally the airline collapsed and declared bankruptcy in 1982 – just within 5 years of operations.

And let’s not forget, that Freddie Laker was considered a business tycoon, a stalwart and was regarded as one of Margaret Thatcher's "golden boys" of industry. Following the successful launch of "Skytrain" in 1977, he was given the honour of “knight” the following year in recognition of his services to the airline industry.

This is what typically happens with such vague and costly assumptions – even big business minds may fail. It took only a year for Dollar to become weaker by 12% as compared to Rupee. The result – 20 lakh people in different export industry sector lost their jobs (official figure). Estimated figure is around 50 lakhs. And when someone in the labour group looses his job, an entire family dependent on him looses the livelihood. We take pride in India Booming and economy surging ahead leaps and bounds – who cares as long as I am getting my MNC salary.

Today, the travel agencies are offering good packages in Rupees for US travel, just because the dollar is cheaper. Just one year back, it was unaffordable for many people and there were no such offers. It all works in market terms. And the sense of market cannot be judged by anyone, as I’ve explained in my previous article on forex trading and how forex rates move.
So the next time you decide to buy shares of a company, just try to get into the fine details of how much forex dependency the company is having. Can it really keep up with the fluctuations in forex rates? Is it using hedging strategies to cover the losses that may occur due to forex risk?

In the next article, I’ll cover the process of hedging and how one can benefit from it.

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