Understanding corporate finance: foreign exchange: the effect of exchange rates on the value of assets and liabilities
Effect of exchange rates on the value of assets and liabilities
Variations in exchange rates will also affect the value of any foreign currency denominated assets or liabilities held by a company.
Suppose a company has an asset denominated in US dollars. This might be shares in a US subsidiary, or a US dollar loan it has made to another company, or a US dollar bank account. If sterling strengthens against the US dollar, each $1 unit is worth less in sterling terms, so the value of the asset - measured in sterling - declines. The company will have made a loss.
The opposite is the case if sterling weakens against the US dollar. The company will get fewer dollars for each pound, or - looking at it the other way round - more pounds for each dollar. So any US dollar denominated asset will be worth more in sterling terms, and the company has made a gain. A US dollar denominated liability will cost more to repay, resulting in a loss to the company.
If, on the other hand, the company has a US dollar denominated liability - for example, it has borrowed in US dollars - it will cost it less in sterling terms to repay the liability. The company has made a gain.
All this is summarised in the following grid:
|£ movement||Foreign currency liabilities||Foreign currency assets|