How can small business deal with today’s currency fluctuations?

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

Right now it’s no secret that selling merchandise to Americans is pretty lucrative.  We also know that it hasn’t always been this way.  A relative of mine who sells lighting products to customers the U.S. is a case in point.

My brother-in-law built a very successful business with his wife from the ground up.  Their decision to sell to markets in the US worked fine, but the real boost to sales occurred when their son joined the business and talked them into selling on the Internet.  Online sales boomed, but of course so did their company’s vulnerability to exchange rate risk.

A few years ago, he was struggling to make his usual margins (which are not that big at the best of times) when the CAD/USD exchange rate approached par.  In other words, a C$ was pretty much equal to the US$.  Cross-border shoppers from the Canadian side of the border were in heaven (myself included), whereas exporters were beginning to panic.  After all, their costs were still in Canadian dollars, which was an advantage when they received sales revenue in a much stronger $US.  Converting back into Canadian currency provided a substantial bonus to their profits and quality of life.

Things are great once again, but how can a smaller business owner(s) plan ahead to make sure that currency risk doesn’t threaten their livelihood?

The graph below illustrates the impact currency can have on a business.  Imagine a fictional Canadian company that began selling a specialty cheese to the U.S. marketplace in June of 2006. The sale price stays the same (due to competitive pressures) at US$ 2.50.  Costs are steady in C$ 1.98 range.  Sales made in US dollars must be converted back to Canadian dollars.  
USD-CAD sales and profits
It is easy to see how just the exchange rate can wreak havoc on a businesses revenues and profitability.  Is it possible to anticipate or prevent this volatility?  When companies are accustomed to very large orders, it is possible to contact your bank and make arrangements to use the currency forward markets in order to ‘hedge’ your profits.  For instance, if one expects to have to convert a significant amount of foreign currency into one’s domestic currency once the order is delivered, you can arrange to lock in the forward exchange rate today, thereby knowing exactly what your margin is (and will be).

However, the orders for most small businesses aren’t large enough to make hedging a viable option. Can you plan for currency fluctuations?  Experts agree that there is no robust way to forecast exchange rates.  Experts have been frustrated trying to predict exchange rates for years, and the forward markets/futures markets are not very good predictors of the exchange rate that will actually occur in 3 to six months.

One approach that has been around (seems like forever) is the purchasing power parity theory.  The price of a consumer product (same materials, can be sourced locally or at same prices) should be the same in different countries, once adjusting for the exchange rate.  Below, the table compares the price of the rather ubiquitous iPhone in Canada, Europe and Asia.  The price of the iPhone 6s 16GB (unlocked) in the U.S. is about $699, and should be more or less the same in Nanjing, China (their currency (is the remninbi or RMB) adjusting for the exchange rate as it is in Berlin Germany (euros).  As you can see from the table, this is not the case (the prices and exchange rates are not 100% accurate due to rounding).

iPhone intl pricing

Because Germans and the Chinese have to pay an even bigger price, it suggests the the USD is overvalued relative to those currencies.  The Canadian dollar on the other hand, based on this overly simple approach is actually still a bit overvalued compared to our neighbour to the south even at these depressed levels.  Of course, our proximity to the US might simply give Canadians a great deal on iPhones not available in other countries.

We should therefore expect the USD to depreciate relative to both the EUR and RMB in due course – the forces of supply and demand (for products, services and therefore currencies) should cause disparate prices to equilibrate.  The mobile device in theory should cost the same to the consumer no matter where he/she lives.  Should the USD decline significantly (perhaps even compared to the Canadian dollar) then the margin on good and services businesses in those countries are earning today with decline.

When sales are in another currency

The problem, is that historically purchasing power parity is also a poor predictor of exchange rates. The game of international finance is extremely complex.  Not only are exchange rates determined by differing interest rates in countries, balance of payments, trade balance, inflation rates and perceived country risks, the rates are also influenced by expectations associated with these variables and more.  The bottom line for smaller businesses is that when it comes to foreign exchange risk – they are completely exposed.

So what can be done?  Planning.  It is tempting to become overly optimistic when exchange rates have drifted in your favour, encouraging further investment to facilitate more sales in the stronger currency.  Buying equipment, hiring permanent labour and leasing more space introduces higher fixed costs that might dampen or destroy profitability when the tide turns the other way.  It is important to consider ‘what if’ scenarios frequently – and especially before laying out more capital. For entrepreneurs the biggest mistake is to take for granted that the status quo will continue.  All of a sudden, you might be buying yourself a bigger house, a fancier car and sending the kids to private school – all based on current income which is linked to the current prosperity of your business.

Currency instability is a fact of life, and the best way to be prepared is to expect the inevitable. Rather than rush to spend more on expanding the business put aside a ‘safety’ cushion during good times that can be drawn upon during bad times.  If your commitment to the US, European or other markets is firm, then park the cushion into currencies you are vulnerable too.  For example, invest your cushion in US dollar denominated assets – U.S. Treasury bills will provide a natural hedge for your sales.  Similarly, if a significant volume of your sales are in Europe and the company borrows funds for operations, borrow some funds in euros as a hedge – then if the euro appreciates you’re able to pay those obligations in the same stronger currency thanks you your euro receivables.

It is widely believed today that the USD is likely to depreciate relative to a number of other currencies, and perhaps imminently.  Today might indeed be the ideal time to begin considering ‘what if’ scenarios and the actions you can take to plan ahead.

 

 

Don’t get whipsawed by Risk Management!

Back in February of 2012, I recall a prominent CFO departing a global insurance company.  This particular individual was labelled “the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.”  The company had suffered financially during the prior market meltdown because of a huge exposure to equity-linked products;  pre-crisis the company had introduced investment products that guaranteed to return a substantial (if not all) amount of the investor’s initial investment.  The money was invested in the company’s funds which in turn invested in stock markets.  During the financial crisis, the value of these assets (stocks) held in the funds declined below the amount that was guaranteed spelling serious trouble for the company.  In response a stricter approach to risk management was adopted after-the-fact.

Sounds sensible doesn’t it?  But it just isn’t!  I’ve watched this pattern time and again over decades.  The fundamental flaw is a complete misunderstanding of what constitutes risk.

Risk is almost always equated to volatility.  For example, stocks move up and down rapidly with much magnitude so they are deemed more risky than bonds.  But are we really as averse to upside risk as downside risk?  Strangely people become more averse to volatility when they’ve suffered downside risk (and come to adore volatility when upside risk has rewarded them).  Because our internal model of risk is so much more complex than mathematics can reckon with, our efforts to ‘manage’ volatility can actually subject us to less volatility but more risk.  When we reduce risk (hedging strategies usually reduce volatility – both up and down) at the wrong times, we miss the chance to be rewarded by the kind of volatility we adore.  We are our own worst enemies.

The President and CEO of a completely different insurance company was quoted as saying this, also in February of 2012:

“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.”

 

This statement followed the company’s earnings release, having reported substantially increased losses from its investments – management had hedged the company’s equity position in 2010 (again, after-the-fact) and suffered investment losses in that year’s fourth-quarter because stock markets rose (instead of declining).  The actions designed to protect the company against volatility lost money.  Risk aversion after-the-fact caused the company to lose money and avoid potential returns from upside volatility.

Because the pain caused by the downside volatility suffered previously was still fairly recent, aversion remained at a high level causing the company to stick to its hedging strategy (in denial?) despite these huge losses, and it continued to lose money as the market continued to go higher and higher still.

The financial crisis is behind us and now that markets are hitting all-time highs, record amounts of dollars are scrambling to get some upside volatility action. Too late?  It’s hard to put a pin in it, but intuitively might one conclude that if managing risk (or ‘risk off’ as they say on business television) was a bad idea during and immediately after the financial crisis, then perhaps chasing volatility (‘risk on’) might not be such a good idea at present?

It might seem as if I was picking on insurance companies earlier, but many pension funds, other financial services companies, portfolio managers and everyday investors follow the same destructive pattern.  Adoring upside risk but loathing downside risk – always at the wrong times – has ruined careers and put a serious dent in the life-savings of families.  More experienced money managers (there are fewer of us nowadays) increase risk when others are most averse to the idea, and begin to manage risk (hedging, raising cash balances) during periods of ‘irrational exuberance.’  They’ve learned the hard way that it’s easier to keep all the hair on your head if you avoid circumstances that make you want to pull it all out.

Mal Spooner