Moshe is an avreich and is considering his options for transitioning into the working world. He and his wife Leah hatch an idea for a new type of tichel. They procure a small gemach loan and use the funds to manufacture the tichels. They convinced two local stores to sell the tichels on consignment. Two weeks later, both stores report that they sold out of the tichels and there is strong demand for more. Now, several stores express interest and there is demand from people all over, including Canada. Moshe enlists his sister-in-law in Toronto to help with sales and ships a few boxes to Toronto, which sell out instantly. While Moshe and Leah’s cross-border sales in Canada look very profitable, they should consider the ramifications of currency risk.
Currency risk is when the volatility of currency exchange rates threatens profitability. Even with robust sales, cross-border trade may not be profitable. This article will discuss the risk aspect associated with currency volatility; a future article will discuss currency risk management.
Consider major Japanese car manufacturers like Toyota, Honda and Nissan. Most of us drive those cars. While those companies are based in Japan, the cars sold in the US market are built in the US. Those car makers have invested billions in creating and maintaining infrastructure in the US. Why have these car makers invested so much here, let them manufacture vehicles in Japan and ship them here? Many will say answer that, due to these companies’ huge North American customer bases, it is more cost effective to build car within the local market instead of constantly shipping cars from Japan.
In reality, it is all about currency risk and has nothing to do with shipping costs. On the one hand there is expanding operations in Japan, paying a Japanese workforce and then shipping the cars and on the other hand there is building new infrastructure in the US, paying an American workforce and not having to ship cars. In weighing the options, the more cost-effective method is the former. Building new operations in the US had a high price tag; a Japanese workforce commands salaries that are approximately 60% of an American workforce; shipping cars is not that expensive. Based strictly on these numbers, Japanese car company building expansion in the United States does not make sense; rather, it is seemingly better business to expand production in Japan and not pay an American workforce. The reason why these mega companies have expansive operations in the US is for one purpose only: currency risk management.
To illustrate, let us go back to our friends Moshe and Leah. To keep it simple, suppose the exchange ratio of Canadian to American dollars is 1:1. They send $5,000 worth of tichels to Toronto with a 100% markup on the sale price, for a total of CAD 10,000. At a 1:1 ratio, they have gross profits of $5,000. Suppose, however, that the Canadian dollar weakens significantly in the interim, wherein the ratio becomes 2:1 or CAD 2 = $1. At this point, the CAD 10,000 that Moshe’s sister-in-law is holding now equals $5,000, which means that Moshe and Leah did not profit off this venture, despite selling all their merchandise. Factor in Moshe paying his sister-in-law for managing the sales and costs for a money changer, they sold their tichels at a loss.
The same is applicable for investors in Israeli real estate, which has become a recent investing trend. Parallel to the United States real estate market, the Israeli real estate market has been super hot. US investors have capitalized on that market. However, there is significant currency risk if the shekel weakens. For instance, in 2007, the Bank of Israel devalued the shekel significantly to propel the technology export market, which was very successful. While overall the Israeli economy saw huge gains when Israeli tech companies had greater ability to export technology due to more favorable exchange rates, foreign investors in the Israeli economy were hurt by the weakened shekel. As a result, some foreign investors into the Israeli economy lost money on their ventures despite robust economic growth.
Therefore, if a money manager is looking to syndicate a deal for a multi-family facility in Saskatchewan and discusses investing with you or if you are reviewing options to invest in an Israeli project, you should ask the money manager about currency risk. If the money manager does not provide a solid plan for currency risk, know that you face additional investing risk.
Currency risk is real and needs to be considered when doing cross-border business. A future article will discuss options to manage currency risk.
Umm, no. Large companies use hedges to mitigate currency risks. US v Foreign production usually comes down to tariffs
That is incorrect. The first step in currency risk management is to create infrastructure in the target market to cut down on currency exchange. I heard from on of the top economists at Credit Suisse that in the 1990s Porsche approached him about managing currency risk in the middle east. He told them to first see if they can create infrastructure in Saudi Arabia. Porsche came back that they cannot, they are not Toyota; they are a much smaller company. After that, he discussed other hedging tools like FX swaps and money market hedges. Tarrifs and shipping are not that expensive when compared to paying an american workforce. So its all about currency risk.
While large multinational businesses, especially with those who have international offices, embark on complex ForEx hedges and forward positions, most companies simply trade in US Dollar denominated transactions only. In fact, most cross border exports like the scenario mentioned here are in fact, traded only in US Dollars. Currency hedges are not viable in most if not all export situations and are not advisable due to the cost and complexity. This letter looks like a prelude to an advertisement for ForEx put options trading, not solid business advice.
That is incorrect. People want to be paid in local currency. People who live in Japan want to be paid in Yen, not dollars so companies cannot do everything in dollar denominations.
This is why my 3rd grade Rebbi in Alabama used to say, “Talmidim, hold on to your Confederate money. The South will rise again.”