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Duration: 7:48

Instructor:

Contributor: Interactive Brokers

Level: Intermediate

When buying shares priced in a currency other than your chosen base currency, there are additional risks and considerations when entering the trade. This lesson explains the presence of currency risk when buying overseas and shows how investors can either manage the currency risk at the time of the trade or use a portfolio margin loan. The lesson demonstrates the impact on P&L under various scenarios for exchange rate and changes in the underlying share price.

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Study Notes:

In this lesson we will explain the complexities of trading stocks in a currency other than your base
account unit. In particular we will show you the various outcomes when buying stock using a Portfolio
Margin loan and the price of the shares rises or falls in combination with a shift in the value of the
borrowed currency. And we will also work through the same iterations when the investor manages the
exchange rate risk rather than borrowing on margin.

At the outset then, there are several identifiable risks and considerations facing investors wanting to buy
shares abroad. As with domestic investments, buying and selling shares in overseas companies contains
trading risks. And of course there is also exchange rate risk, which could impact P/L adversely or
positively. In fact as you will learn later in this video, currency movements can wipe out gains on the
underlying investment. Because we are discussing overseas trades, there is an associated settlement
concern, which may simply create additional problems due to holidays in the country where the trade
settles. Investors may need additional market data subscriptions especially if they want live market data
for stocks which they are holding or even monitoring.

Because IBKR connects to more than 100 global market venues and offers clients a base account in more
than 20 foreign currencies, it has sophisticated monitoring software. What we are about to illustrate in
this video revolves around a critical piece of software known as the IB Credit Manager. This apparatus
automatically checks the status of a client’s account at the point of trade entry. And depending on the
account status, Credit Manager makes a set of logical decisions.

When the Client enters a foreign stock transaction, Credit Manager checks the associated currency
account for availability:

  • If foreign currency is available – Credit Manager permits the stock trade and debits the currency account
  • If foreign currency is NOT available – Credit Manager creates a Margin Loan using base currency as
    collateral and THEN permits the transaction.

Note Margin Loan is only for Margin accounts – loans are not permitted in Cash accounts
Alternatively: The client may BUY currency ahead of time in which the foreign stock will settle. The
bought currency will appear in the Account Management window as a Cash credit.

Or the Client may attach an FX order to the stock transaction when creating the order. If the parent
stock order begins to fill, the FX child order will start to fill.

We will look now at the case of a US investor buying shares trading in a British company on the London
Stock Exchange. We will examine three cases starting with what happens when the investor converts
currency as shares are bought. Later, we will look at two cases when using a margin loan and finally, try
to draw some conclusions. Each scenario begins with the following assumptions.

A US investor has a $15,000 account and wants to buy shares in ABC Corp. in London trading at £1.00
each. At the outset, the current rate of exchange means that the British pound buys $1.50. It’s
unimportant that investor has greater buying power, but you should understand that the sterling
equivalent value of the account is £10,000 at that starting exchange rate.

Currency Conversion – Case 1

  • Investor SELLS $15,000 and buys pounds at the exchange rate of Stg/$1.50. The account now has
    Stg10,000 and can buy 10,000 shares at Stg1.00 each
  • Over a few months, the share price has not moved, but the pound has weakened, buying fewer dollars –
    Stg/$= 1.40.
  • Liquidating shares at Stg1.00 each and exchanging Stg10,000 at the rate of $1.40 yields $14,000 for a
    $1,000 loss.

Currency Conversion – Case 2

In the second case, this time the pound strengthens relative to the dollar. One pound now buys $1.60.
Multiplying Stg10,000 by the exchange rate now means the investor has $1,000 gain when returning his
cash to dollars.

Currency Conversion – Case 3

Now let’s assume Shares rise by 10% so that the investor has a Stg1,000 capital gain. On screen displays
the impact of that capital gain on the stock when the dollar gains, remains the same and declines versus
the pound.

And if shares fall 10%, the investor has a Stg1,000 capital loss. On screen displays the impact of that
capital loss from the stock when the dollar gains, remains the same and declines versus the pound
Let’s turn now to some iterations when a margin loan is used to fund the share purchase abroad. In
practical terms, at the point of the share transaction, the cash account in the settlement currency (in
this case British pounds) is zero. The Credit Manager software automatically creates a margin loan
recognizing that the sterling account is in deficit to the value of the bought shares.

Margin loan

When the investor buys 10,000 shares, Credit Manager deals a Stg10,000 margin loan secured against
the US$ collateral in the investor’s account. No matter what happens, the investor has to repay that loan
after the shares are sold. If the share price falls, there will be a shortfall. If the share price rises, there
will be a surplus in the British pound account.

Case 1 –

The Share price rises 10% – the loan is repaid but leaves a Stg1,000 gain – on display you can see the impact of the dollar rising, staying the same and falling on the value of that capital gain when it is exchanged back into US dollars.

Case 2 –

Shares fall by 10% – the loan repayment falls short by Stg1,000 after the price decline – the display illustrates the impact of the shortfall when the dollar rises, stays the same and falls on that margin loan shortfall of Stg1,000.

Pros and Cons

  • With the Currency Conversion
  • The investor faces currency risk on the principal sum
  • There may be daily P&L impact due to currency risks
  • But there are no finance charges

Margin Loan

  • Currency risk is removed from the principal sum
  • Capital loss on equity may create a debt of greater value than the original size of the loan
  • There may be daily P&L subject to currency risk
  • There may be finance charges depending on the yield spread between the base and overseas
    currency
  • Base deposit accrues interest
  • Margin loan incurs interest

These are the Mechanics of an Overseas Stock Transaction and you should be able to see the risks between margin loan and currency conversion. In our next lesson, we demonstrate how to create both types of trade using TWS.

In summary: Currency movements will affect P&L when performing transactions using non-base currency units. The investor needs to consider the benefits or drawbacks of managing currency risk or taking out a margin loan.

Before you attempt to place overseas trades, make sure that you understand the process and understand how order attachments work in TWS.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Supporting documentation for any claims and statistical information will be provided upon request.

Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

Disclosure: Forex

There is a substantial risk of loss in foreign exchange trading. The settlement date of foreign exchange trades can vary due to time zone differences and bank holidays. When trading across foreign exchange markets, this may necessitate borrowing funds to settle foreign exchange trades. The interest rate on borrowed funds must be considered when computing the cost of trades across multiple markets.

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