Case Study: FX Stock Trades

Study Notes:

Case Study – A U.S. Investor Buys Stock in a British Company

For illustrative purposes:

• Let’s say you’re a U.S. investor who’s buying shares in a British company that’s trading on the London Stock Exchange (LSE).
• Let’s assume that you have $15,000 in U.S. dollars your account, and you’re looking to purchase shares in ABC Corp., which are trading in London at £1.00 (one pound) apiece.
• At the outset, the prevailing rate of exchange gives the British pound the power to buy $1.50 worth of U.S. dollars, placing the sterling equivalent value of your account at £10,000.
• Given this, let’s take a look at what can happen to your P&L under different scenarios when your U.S. dollars are converted to British pounds. 

Foreign Currency Moves

Let’s say, for example, you’ve sold your $15,000 and bought pounds when one pound was worth $1.50. This gives you 10,000 pounds in your account, with which you decide to buy 10,000 shares of ABC Corp at 1 pound apiece.

Over the next few months, while the share price of ABC Corp hasn’t moved, the pound has weakened – it now buys only $1.40 upon conversion. Now, when you liquidate your shares at 1 pound apiece and go to exchange your 10,000 pounds, you only receive $14,000 – meaning, you’ve just suffered a $1,000 loss.

Now let’s say that instead of weakening, the pound strengthens versus the U.S. dollar. One pound now buys $1.60. When converting that 10,000 pounds after liquidation, under this exchange rate, you’ll receive $16,000 – or a thousand-dollar gain.

Share Price Moves

If ABC Corp shares should rise by 10%, you’ll experience a capital gain of 1,000 pounds. But depending on the exchange rate of the pound versus the U.S. dollar, you’re going to have different outcomes.

If the pound buys $1.40, $1.50 or $1.60, for example, you’ll have gains of $400, $1,500 and $2,600 worth of gains in your account, respectively.

Conversely, if shares in ABC Corp fall by 10%, you’ll suffer a 1,000-pound capital loss, and upon converting your currency after liquidation back to U.S. dollars, you’ll see your account fall by $2,400, $1,500, or $600, should the exchange rate of the pound versus the U.S. dollar yield $1.40, $1.50 or $1.60, respectively.

Foreign Exchange Rate Risk

As you can see from these examples, with the currency conversion, you’ll face currency risk on your principal sum, as well as the potential for daily P&L impacts. However, you won’t experience any finance charges as you could when making these same transactions on margin.

So, let’s take a look at what happens when using margin to fund this overseas share purchase.

In practical terms, at the point of the share transaction, your cash account in the settlement currency (in this case British pounds) is zero. Your margin account software may automatically create a margin loan, recognizing that your sterling account is in deficit to the value of the shares purchased.

When you buy 10,000 shares of ABC Corp at 1 pound per share, you’ll see a 10,000-pound margin loan secured against the U.S. dollar collateral in your account.

Remember, no matter what happens, you’ll need to repay that loan after the shares are sold. If the share price falls, there will be a shortfall, and if the share price rises, there will be a surplus in your British pound account.

Let’s say the share price rises by 10%. This change results in an amount sufficient not only to repay the loan, but also yields a post-sale gain of 1,000 pounds. However, the dollar value of this gain will depend on the performance the pound versus the dollar. A weaker dollar will translate to higher gains and vice versa.

Recall that there is an inverse relationship between a foreign currency and the U.S. dollar, where a strong dollar signals weakness in the foreign currency unit, and a weak dollar indicates foreign currency strength.

If your shares in ABC Corp fall by 10% – the repayment on your loan will fall short by 1,000 pounds. To pay the loan balance, you’ll need to sell U.S. dollars to fund the overseas deficit. The amount of U.S. dollars needed depends on the exchange rate. As the pound strengthens, the dollar value needed to reply the loan rises. In this case, you’ll benefit by a stronger dollar, since the shortfall is reduced.

When making foreign currency stock transactions on margin, you can see that the currency risk you experienced on your principal sum, when trading in your cash account, is removed, however your daily P&L remains subject to this risk.

Also, capital losses you suffer on your equity may create a debt of greater value than the original size of your margin loan, and you may also experience finance charges, depending on the yield spread between your base and overseas currency. And while your base deposit accrues interest, your margin loan will incur interest.

These are the mechanics of an overseas stock transaction, and from these scenarios, you should now be able to assess the risks between margin loan and currency conversion. Overall, you should also weigh the benefits and drawbacks of managing currency risk or taking out a margin loan.