How Forex Relates to the Equity Markets
Foreign exchange and equities markets are driven by changes in interest rates. Increases or the prospect of increases in domestic interest rates will generally raise the value of the local currency while it will tend to depress domestic equity markets.
As a result, during periods of sustained interest rate increases, equities markets can become unattractive and foreign exchange trading attractive.
Today, major global companies earn an increasing share of profits overseas. Fluctuations in the currency rates of key foreign markets relative to home currencies will have a direct impact on earnings and, therefore, share prices.
Investors holding a portfolio of large multinational stocks therefore are indirectly participating in the foreign exchange markets. Some investors take the next step by overlaying currency trades atop the FX market exposure in their equities portfolio or trading FX outright.
In calculating the FX exposure of an equities portfolio it's useful to keep in mind that companies can mitigate the impact of fluctuating FX rates on earnings. This is done by hedging directly using FX instruments or by establishing a network of suppliers and manufacturing facilities within key markets to create natural currency hedges.