Mergers And Acquisitions - Another Tool For Traders

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 à Average 1% Appreciation in Target's Currency
Every $1 Billion à 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.