Dollar Strengthens

Amid high inflation, rising interest rates, and a faltering stock market, one bright spot has been the performance of the U.S dollar. Since the beginning of the year, the dollar has risen 17 percent against the British pound, 25 percent against the Swedish krona and Japanese yen, and an astounding 40 percent against the Argentinean peso. Two currencies that have strengthened compared to the dollar are the Mexican peso and Brazilian real. 

Onshoring

Which automobile company exports the most cars from the U.S.? Most people would probably guess Ford or GM, but for the 8th straight year, BMW is the U.S. auto export leader. During 2021, BMW exported 257,876 cars valued at $10.1 billion from the company's plant in the U.S. Although many are concerned with the negative effects of offshoring manufacturing, there are also benefits to onshoring. 

LIBOR End Is Near

The Financial Stability Board (FSB), which coordinates financial rules for G20 countries, outlined its new transition polices to move away from LIBOR by the end of 2021. A number of U.S. dollar LIBOR rates will be available until the end of June 2023, but can only be used for legacy contracts. The FSB is encouraging the use of overnight risk-free rates, which include SOFR in the United States and SONIA in Great Britain.

LIBOR Termination Extended

The administrator of the London Interbank Offer Rate (LIBOR) has extended the termination of some tenors until mid-2023 to allow users more time to change to another reference rate. However, the 1-week and 2-month U.S. dollar LIBOR rates will end on December 31, 2021. In the U.S., SOFR appears to be the new standard, but SOFR is not without it's own issues. SOFR does not allow treasurers to estimate forward interest rates, a major drawback. Even with this shortcoming, companies need to transition from LIBOR before it runs out.

Big Bang Goes Off Smoothly

It appears that the "big bang" over the past weekend went relatively smoothly. The big bang was the transition from LIBOR to the Secured Overnight Funding Rate (SOFR) for exchange-traded swaps at the Chicago Mercantile Exchange. The LIBOR scandal in 2012 caused regulators and market participants alike to search for another reference interest rate that was less susceptible to manipulation. In the U.S., SOFR has become that reference interest rate.

Currency Fluctuations Damage Earnings

In its latest report, Kyriba estimates that North America companies earnings fell by $10.77 billion due to currency fluctuations last quarter. The most common currencies affecting earnings were the Brazilian real, the euro, and the Mexican peso. The industry that was most affected was Healthcare Equipment & Supply. In contrast, European companies had a negative earnings impact of $1.44 billion.

U.S. Dollar Rises

With the economic turmoil from the COVID-19 virus, the U.S. dollar rose again. During economic uncertainty, the dollar gains value as investors seek stability, and the U.S. dollar is generally regarded as one of the safest, if not the safest, currencies in the world. For the week, the dollar is up about 3 percent against a basket of other currencies. Surprisingly, the dollar is also up against the Japanese yen, which is also regarded as a safe haven currency.

FX Hurts North American Profits

According to a recent report, currency exchange fluctuations reduced North American corporate profits by $11.55 billion in the third quarter of 2019. The loss amounts to an average reduction of $.03 in EPS. The euro was the currency which caused the most losses, affecting about 46 percent of companies. The British pound, Argentine peso, the Australian dollar, and Chinese yuan were next on the list of most impactful currencies.

Coca-Cola's Currency Risk

In a recent interview, Coca-Cola CFO John Murphy discussed the currency risks facing the company. For the most recent quarter, Coke's earnings were reduced 9 percent because of currency fluctuations. The increase in the value of the U.S. dollar is the primary driver of the loss. Murphy expects currency losses to be only about 6 percent in the third quarter. One interesting point in the article is the sheer scope of Coke's multinational operations: The company is exposed to more than 70 currencies.

Dollar Gets Expensive

The most recent Big Mac Index from The Economist shows that, using purchasing power parity to compare the price of Big Macs in different countries, the U.S. dollar is very strong. In only one country, Switzerland, is the currency overvalued compared to the dollar. In every other country examined, the currency is undervalued when compared to the dollar. When GDP is taken into account, five currencies are overvalued compared to the dollar. Looking at Britain, the pound reached a high of about 25 percent overvalued in 2008 to its current 16 percent undervaluation. Remember, a strong dollar means that U.S. consumers can buy foreign goods more cheaply, resulting in more imports. At the same time, U.S. exports become more expensive to foreign buyers, thereby reducing exports.

Slow Earnings Repatriation

One goal of the Tax Cuts and Jobs Act of 2017 was to increase repatriation of overseas earnings. Broadly speaking, new repatriated earnings are not subject to additional taxes that were in force under the previous tax system. A common misconception is that most of the $3 trillion in foreign earnings earned held abroad by U.S. companies was sitting in stockpiles of cash. In the second quarter of 2018, companies repatriated $169.5 billion, which is up significantly from the $34.9 billion in the second quarter of 2017, but down from the $294.9 billion repatriated in the first quarter of 2018. Several factors have reduced the expected tax windfall, including a company’s desire to leave cash overseas for investment to foreign laws that limit a company’s ability to repatriate cash to the U.S.

Currency Losses Decline

In a recent survey of 296 North American and European multinational companies for the fourth quarter of 2016, they lost a combined $10.47 billion due to currency swings, down considerably from $36.85 billion a year earlier. The average effect of these swings on EPS was $.04. The currencies that were mentioned the most as causing losses were the British pound, the euro, The Japanese yen, the Brazilian real and Canadian dollar.

International Risk

Political risk exists in varying degrees, but the most severe is appropriation of a company's assets. GM became the latest company to have its assets appropriated in Venezuela as the government of that country took control of GM's remaining plant. The plant had stopped producing cars in 2015, manufacturing only spare parts since. GM joins a list of companies, including more than 60 oil companies, meat processing plants, rice farms, and the Manpa toilet paper plant, that have had assets seized by the Venezuelan government. In March, ExxonMobil had parts of a $1.4 billion award related to seizure of its assets by the Venezuelan overturned.

Loonie Taking Flight?

Since 2012, when the Canadian loonie reached parity with the U.S. dollar, the currency has taken a nose dive, dropping to a low of C$1.46 in early 2016. One benefit for Canada is that the cheap loonie created a trade advantage, helping that country's exports and benefiting the economy. With a better economy, whether the loonie will once again take flight is an important consideration for U.S. companies doing business in Canada. Strengthening of the loonie will increase the cost of goods imported to the U.S. from Canada, thereby reducing profits. These companies can lock in costs with forward contracts for commodities, or by hedging currency risk with futures, options, or swaps.

Dollar Strengthens

With housing starts at a the highest point in nine years and the weekly jobless claims reaching a 43-year low, it appears that the U.S. economy is strengthening. As a result, it now appears likely that the Federal Reserve will increase interest rates in its December 13-14 meeting. This also lead to a stronger U.S. dollar as the dollar reached a 13 1/2 year high against a basket of six major currencies. The U.S. dollar reached its highest level against the euro in almost a year, and its highest level against the yen since early June.

Corporate Overseas Cash Grows

The cash held by foreign subsidiaries of U.S. companies has reached a record $2.5 trillion. Microsoft and GE both hold more than $100 billion overseas, while Apple and Pfizer have $91.5 billion and about $80 billion, respectively. Overseas cash now tops cash held domestically, which reached $1.94 trillion. Of course, much of the reason for the foreign cash holdings is the U.S tax system, which taxes repatriated earnings at 35 percent, the highest corporate tax rate in the world. Although various tax breaks on the repatriation of cash have been floated, naysayers argue that the last repatriation tax break in 2004 resulted in little investment. Rather, repatriated cash was used for dividends and stock buybacks. We should point out that a repatriation tax break would actually be a boon to the IRS. Consider, if the repatriation tax rate were lowered to 15 percent, companies would only get $.85 for every dollar repatriated. Assuming a 35 percent personal tax rate, investor would only receive about $.55 in dividends after tax per dollar repatriated, an effective tax rate of about 45 percent.

Currency Trading Shrinks...Maybe

So how much currency do you think is traded daily? According to a recent report published by the Bank for International Settlements (BIS), average daily trading in April 2016 was about $5.1 trillion! This was down from $5.4 trillion per day in April 2013. However, if the dollar had not appreciated over the period, average daily volume would have risen about 4 percent. Spot currency trades were about $1.7 trillion per day, swaps accounted for about $2.4 trillion per day, and the rest of the trading was for other over-the-counter foreign currency derivatives. The U.S. dollar was on one side of 88 percent of trades, while the euro was on 31 percent of trades.

Negative Yield Triangular Arbitrage

A question we often get is if the material we discuss is actually relevant to the real world. However, we can see the application of triangular arbitrage with the seemingly strange desire of investors to purchase the $9 trillion in below zero interest sovereign debt. A Japanese 3-month government bill is currently returning about negative .24 percent. The buyer can borrow at the yen 3-month LIBOR, which is about negative .02 percent and receive the dollar LIBOR at .82 percent. The buyer then executes a yen-dollar swap, which results in a dollar-hedged yield on the trade of 1.24 percent. With the 3-month U.S. Treasury yield about .25 percent, and increase in annualized return of about one percent is a huge increase for portfolio managers.

Hedging Exchange Rate Risk

As we mentioned in the textbook, companies often want and need to hedge exchange rate risk. A recent article in Treasury and Risk gives a good primer on methods to hedge exchange rates. First, a company must have an accurate forecast of foreign cash flows. With any forecast, GIGO (garbage in, garbage out) applies to hedging exchange rates. If the forecast is inaccurate, the company will over hedge or under hedge its exchange rate risk. Another suggestion made in the article is a layered hedge, which may help to reduce volatility. This means that a company does not hedge all of its exchange rate risk at a particular point in time, but rather hedges part of the expected exchange rate risk, then adds to the hedge over time as the date of the currency exchange approaches. If you are interested in hedging exchange rates, we suggest you read further. 

American Airlines Political Risk

Although we don't delve deeply into political risk as it is beyond the scope of the textbook, it is a risk borne by multinationals as American Airlines found out. American recently announced that it would take a $592 million special charge in the fourth quarter as a result of Venezuelan currency controls. Venezuela's socialist government forces airlines to sell airfares in bolivars, but makes conversion of the bolivars into U.S. dollars difficult. As a result, American has bolivars trapped in Venezuela.