Understanding corporate finance: foreign exchange: managing exchange risk: borrowing in a foreign currency
Borrowing in a foreign currency
If sterling weakens against a foreign currency, a company’s assets denominated in that currency (such as foreign currency bank deposits or investments) become more valuable in sterling terms: but liabilities become more onerous - it costs the company more to repay borrowings in that foreign currency. Purchases made in the foreign currency become more expensive, but sales are worth more in sterling terms. The opposite happens if sterling strengthens.
Companies will generally want to reduce their exposure to exchange fluctuations. Suppose that a company has borrowed $1 million at a time when $1 million was worth £625,000. When it comes to repay the loan, $1 million is worth £650,000. The company has realised a loss of £25,000. Clearly this is likely to be of concern to the company treasurer, particularly if having to find £650,000 to buy the dollars to repay the loan upsets the company’s cashflow forecasts. But he or she may be almost equally concerned if, having budgeted say £640,000 to repay the loan, exchange rates suddenly move the other way and it costs only £600,000.
It is not only realised exchange gains and losses that concern companies. Suppose that the company has borrowed the $1 million for five years. For accounting purposes, it will, at the end of each period of account, translate the loan into sterling at the rate prevailing on the last day of the accounting period. So its accounts will show an unrealised exchange gain or loss: a loss in one year, in which sterling weakens against the dollar, may be followed by a gain the next year, in which sterling strengthens. Companies may perceive such unrealised gains or losses as distorting their financial results.
Almost all large companies, and many smaller companies that have a currency exposure, will therefore seek to hedge their exposure in some way.
A very common way of reducing currency exposure is for a company which is buying a foreign currency denominated asset, or acquiring foreign currency investments, to borrow in the same or a related foreign currency. For example, a company may put Can $2 million, in the form of equity, into a Canadian subsidiary, borrowing Can $2 million from the bank in order to do so. If the Canadian dollar weakens against sterling, the company’s shares in the Canadian company will become worth less in sterling terms, but 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.