One of the most important things you will learn when trading the currency market is that the world is interconnected. The stock, bond, commodity and currency markets all have a hand in each other's business. There is no rule written in stone about which market has a leading or lagging effect on another. Rather, any one of the markets can lead or lag the other markets. In the article Bond Spreads: A Leading Indicator For Forex, we looked at how movements in the bond market can be used to trade in the forex (FX) market. Here we will focus on how the stock market can impact the currency market and how traders can use this information to identify trading opportunities.

How Are the Two Connected?
The equity market can impact the currency market in many different ways. For example, if a strong stock market rally happens in the U.S., with the Dow and the Nasdaq registering impressive gains, we are likely to see a large influx of foreign money into the U.S., as international investors rush in to join the party. This influx of money would be very positive for the U.S. dollar, because in order to participate in the equity market rally, foreign investors would have to sell their own domestic currency and purchase U.S. dollars. The opposite also holds true: if the stock market in the U.S. is doing poorly, foreign investors will most likely rush to sell their U.S. equity holdings and then reconvert the U.S. dollars into their domestic currency - which would have a substantially negative impact on the greenback. This logic can be applied to all the other currencies and equity markets around the world. It is also the most basic usage of equity market flows to trade FX.

We attempt to take equity flows one step further by looking at how currency traders can use merger and acquisition (M&A) news to trade FX. In basic terms, mergers and acquisitions are a combination of two or more companies, or the acquisition of a part of a corporation for which some payment is given in compensation. This payment can be in stock, cash or a combination of the two. (For an in-depth look at M&As, see our tutorial The Basics Of Mergers And Acquisitions.)

Professional FX traders will generally focus on large cross-border M&A activities greater than US$1 billion. The key is for traders to look primarily at cross-border flows rather than every large M&A transaction. Why is this important? Because a cross-border M&A transaction is a transaction in which the target company and the acquiring company are from different countries: this means that, in order to make the deal complete, there must be some sort of currency transaction. If the deal involves no cash, a simple payment to the bankers for conducting the deal may be all we're looking at, but if the deal does involve cash, the significance and potential impact of the transaction is far greater.

How Can This Information Be Used?

  • M&A Deals = Average 1% Appreciation in Target's Currency
  • Every $1 Billion Deal = 0.5% Positive Impact on Target's Currency

In a study conducted in 2000 by Francis Breedon and Francesca Fornasari of Lehman Brothers entitled "FX impact of cross-border M&A", it was found that, on average, large M&A deals cause the domestic currency of the target corporation to appreciate by 1% relative to the acquirer's. For every $1-billion deal, the currency of the target corporation increased in value by 0.5%. More specifically, the report found that in the period immediately after the deal is announced, there is generally a strong upward movement in the target corporation's domestic currency (relative to the acquirer's currency). Fifty days after the announcement, the target currency is then, on average, 1% stronger. However, the study found that this currency impact tends to peak at approximately 5%.

According to our observation, since the market is predominantly an expectations market, we generally see a large portion of the move that can be attributed to M&A activity occur within the first week of the announcement.

Gauging the Impact
Generally speaking, each deal can have a very different impact on the currency market, and one of the ways to interpret the potential size of the impact is to look at the specifics of the deal to see how it is structured. For example, an all-cash deal will have a much more significant impact on the currency market than an all-stock deal. The reason should be obvious: a cash deal, particularly one worth $1 billion or more, would automatically mean that a large transaction would be needed to convert currencies for payment.

An all-stock deal, on the other hand, will mean a smaller currency conversion and probably one that is done over a longer period of time. An all-stock deal may give current foreign shareholders of the acquiring firm the opportunity to sell their shares if they do not believe in the deal, or it may lead more traders, both domestic and international, to snap up more shares of the target company in the hope that it may be sold at a higher value than the price at which it is currently trading. On a more medium-term basis, a cross-border acquisition could also mean that the geographical distribution of shareholders will be much more diverse, so when it comes time to hand out dividends, we may see more international investors repatriate their dividend payments.

A deal that is a combination of both stock and cash has a more mixed effect on the currency pair, with the actual magnitude of the impact dependent upon the percentage of cash involved in the deal.

  • All-Stock Deal:Minimal Impact
  • Stock & Cash:Impact Based Upon % of Cash

Putting Theory into Practice
Although there are many factors that may be impacting a currency pair at the time, the announcement of a large M&A deal can have a meaningful impact on the pair's price action. In each of the following three examples, the target corporation's currency appreciated significantly against the acquirer's currency in the days, weeks and months following the announcement of the acquisition.

Figure 1 is an illustration of the price action in the GBP/CHF following an announcement by Holcim Ltd Reg (a Swiss company) that it planned to acquire Aggregate Industries (a U.K. company) for £2.2 billion ($4.1 billion) cash, which means that Holcim would need to sell Swiss francs and buy British pounds. On the day of the announcement, GBP/CHF rallied 150 pips. Two weeks later, GBP/CHF was at least 450 pips higher.

Figure 1 - Holcim Ltd Reg announces acquisition of Aggregate Industries PLC for £2.6 billion ($4.1 billion) <+GBP/CHF>.

Figure 2 is an illustration of the price action in EUR/GBP following an announcement by Pernod-Ricard (a European company) that it would be acquiring Allied Domecq PC (a U.K. company) for £9.6 billion ($17.8 billion) through a combination of 80% cash and 20% stock. This was a huge deal, and even though EUR/GBP rallied 40 pips on the day of the announcement, it ended up more than 125 pips lower over the next week and 194 pips, or 2.8%, lower at the end of 50 days. For EUR/GBP, this was a big move.

Figure 2 - Pernod-Ricard announces acquisition of Allied Domecq PLC for £7.5 billion ($17.8 billion) <-EUR/GBP>.

The next example, seen in Figure 3, is the announcement by Procter & Gamble (a U.S. company) of a 77% acquisition of Wella AG (a European company) for US$4.5 billion. On the day of the announcement, the EUR/USD jumped over 100 pips, and in the week following the announcement, the currency pair was 200 pips higher.

Figure 3 - Procter & Gamble announces 77% acquisition of Wella AG for US$4.5 billion <+EUR/USD>.

The last example of a large cross-border transaction having an impact on the currency market is Great West Life's (a U.S. company) acquisition of Canadian Life (a Canadian company) for US$4.7 billion. As we can see in Figure 4, on the day of the announcement, USD/CAD dropped approximately 50 pips, but in the week following the announcement, the currency pair was more than 250 pips lower. Three weeks after the announcement, it was close to 600 pips lower.

Figure 4 - Great West Life Co announces acquisition of Canada Life for US$4.7 billion <- USD/CAD>.

Finding Information
If you are interested in following M&A flows, the news of these large transactions will usually appear in papers such as the Financial Times and the Wall Street Journal. Yahoo Finance and CNN Money also regularly publish reports on top M&A flows.

The preceding examples all serve to illustrate the interconnectedness of the markets. Major cross-border M&A activity can have a considerable impact on the currencies involved in the transaction. Astute FX traders can use this information to identify trading opportunities that others might miss.

Related Articles
  1. Forex Fundamentals

    How Foreign Exchange Affects Mergers and Acquisitions Deals

    Learn how foreign exchange rates can impact the flows of international merger and acquisition (M&A) transactions, and understand how deals can impact exchange rates.
  2. Chart Advisor

    Pay Attention To These Stock Patterns Playing Out

    The stocks are all moving different types of patterns. A breakout could signal a major price move in the trending direction, or it could reverse the trend.
  3. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  4. Economics

    Long-Term Investing Impact of the Paris Attacks

    We share some insights on how the recent terrorist attacks in Paris could impact the economy and markets going forward.
  5. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  6. Technical Indicators

    Using Pivot Points For Predictions

    Learn one of the most common methods of finding support and resistance levels.
  7. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  8. Forex Education

    Top 6 Most Tradable Currency Pairs

    The most frequently traded currency pair is the euro/U.S. dollar. The euro is the base currency in the pairing, while the dollar is the quote currency.
  9. Chart Advisor

    Watch These Stocks for Breakouts

    These four stocks are moving within price patterns of various size, shape and duration, and are worth watching for a breakout
  10. Forex Fundamentals

    How to Buy Chinese Yuan

    Discover the different options that are available to investors who want to obtain exposure to the Chinese yuan, including ETFs and ETNs.
  1. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  2. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  3. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  4. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  5. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  6. How is the value of a pip determined?

    A pip in foreign exchange trading is a measure of a price movement in a currency pair. "Pip" is an acronym for price interest ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center