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.

FX-MA1_r.gif
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.

FX-MA2_r.gif
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.

FX-MA3_r.gif
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.

FX-MA4_r.gif
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.

Conclusion
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.

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