CFM12040 - 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, as expressed in a particular currency. It is not necessarily that the inherent value of the asset that have changed, rather the exchange rates movement has changed the value as expressed in a particular currency. So if a debt asset has a value of $1,000,000, the amount expressed in sterling will change according to the exchange rate.

Assets

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. In sterling terms, 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.

Note that, either way, if the value of the asset is measured in dollars and remains equal to face value, nothing has happened. If the value is measured in euros, a gain or loss may arise according to changes in the exchange rate between the US dollar and the euro.

Liabilities

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 in the event that sterling strengthens against the US dollar. The company will have made a gain.

This is summarised in the following grid:

£ movement	Foreign currency liabilities	Foreign currency assets
£ strengthens	Gain	Loss
£ weakens	Loss	Gain