Using mergers and acquisitions in forex trading

The relationship between the stock and forex markets

The stock market can impact the forex market in a number of ways. For instance, if a strong stock market rally  happens in the UK, with the FTSE 100 and FTSE AIM All-Share making large moves, this is likely to result in a flow of foreign capital into the UK as international investors want to profit on the trend. As a result, the British pound would rise as foreign investors would have to purchase GBP in order to participate in the British markets, increasing demand for the currency.

The opposite is also true – if the UK stock market falls, foreign investors will choose a better-performing market, selling their pounds to invest in another currency, resulting in the GBP falling in value as supply overtakes demand.

Taking this one step further, we can infer that mergers and acquisitions (M&As) which boost the stock market are likely to boost the local currency. Professional currency traders will usually focus on cross-border M&As worth over USD1 billion. As cross-border transactions will result in the acquiring company having to pay the price for the target company in the target company’s currency (in the case of a merger, a deal in which one of the currencies is converted is also likely to take place).

Large M&A deals cause the domestic currency of the target company to appreciate relative to the acquirer’s currency, according to a study conducted by Francis Breedon and Francesca Fornasari of Lehman Brothers in 2000. They found that for every USD1 billion deal, the target company’s currency would increase by 0.5%, and would be 1% stronger fifty days after the announcement. However, the study found that the currency impact tends to peak around 5%.

So if an American company took-over an Australian company, the AUD/USD pair would quickly rise by 0.5%, registering a 1% gain at the fifty day mark.

Determining the impact

Each deal can have a different impact on the forex market, and one way to predict the potential size of the impact is to check how the deal is structured. An all-cash deal will have a much more significant impact on the forex market than an all-stock deal.

An all-cash deal would result in a large transaction and, consequently, a large demand for the target company’s currency, whereas an all-stock deal would result in smaller currency movements over time as foreign shareholders buy and sell the shares. An all-stock deal could also result in a diverse geographical distribution of shareholders, resulting in international investors repatriating their dividend payments, which may also impact the currency value.

The impact of a deal that is a combination of stock and cash will depend on the proportion of the deal that is cash – the higher the cash proportion, the larger the impact on the forex market.

Trading forex with mergers and acquisitions

Although numerous factors impact different currency pairs, the announcement of a large M&A deal can have a meaningful impact on a pair’s price.

On February 9, the Deutsche Bourse confirmed a takeover deal with the NYSE. The deal was valued at USD10 billion and, to make the takeover, the Deutsche Bourse would need to convert Euros into US dollars, thus creating a higher demand for US dollars.

On February 9, the EUR/USD forex pair rose from its opening price of 1.36251 to a high of 1.37440, a jump of 118.9 pips in one day. Over the next fifty days, the pair reached a high of 1.42484 on March 22, falling to 1.4174 on March 30, or day fifty. This is a total increase of 522 pips, or a gross profit of USD5,220.

EUR/USD February to April 2011. Source - Onada

The following chart shows the AUD/CAD from August to November 2010. On the weekend of August 14, Canadian firm Agrium Inc made an unsolicited bid for Australian grain seller AWB Ltd of AUD1.2 billion. 

Although there wasn’t much movement in the currency pair that weekend, on Monday the 16^th the pair rose from an opening price of 0.93089 to a high of 0.93905, a rise of 81 pips. Over the next fifty days, the pair rose to 0.99276. It continued to rise to 1.00536 before the pair grew more volatile in November through to March, though this subsequent rise was probably unrelated to the takeover bid.

AUD/CAD August to November 2010. Source - Onada

Although numerous factors affect the forex market, take large, cross-border mergers and acquisitions into consideration when you trade can help you identify trading opportunities that others might miss.