Foreign Exchange Risk

See: Foreign Exchange.

Bretton-Woods (no relation to Tiger) fixed exchange rates. For strategic reasons. And yeah, we’re not talking about some country club kid named “Bretton.”

The Bretton-Woods Agreement was established in 1944, near the end of WWII, between the U.S. and a few other countries, who all agreed that it might be in everyone’s best interests to, um…get along.

And not just in terms of…not blowing each other up…but also in terms of building friendly trade, so that if we did blow each other up some day, we'd all have something to lose. So these countries got together, decided how much each country’s currency was worth relative to every other country’s currency, and decided to set those currencies at a fixed rate, thereby allowing for future international trade.

However, floating is vastly the more common form in which currencies around the world trade. Like…that floating thing basically just means that there are no rules for how one currency is valued relative to another. If suddenly Putin decides to print boatloads of rubles, destroying the relative value of their currency against more or less all other currencies in the world, then the ruble-to-dollar exchange rate might suddenly gap down to a dollar buying 100 rubles, instead of the 50 it was buying last month.

The same can work in the other direction as well. If The Russian Fed or Central Bank decides to raise rates dramatically, wanting to protect the value of its currency globally, making its currency more scarce and or precious, well, the same exchange rate might suddenly float the other way. Like, all of a sudden, a dollar only buys 20 rubles or less.

Or the reverse could be true…that you might go back to a world from $1 buying 20 rubles to one ruble buying $20, if the Russians end up defending their currency the way they’ve defended their best election hackers. You can imagine how a country could go bankrupt trying to "defend" its currency. An easy path there (and this path almost bankrupted Europe when the euro came out) was to set a price ceiling.

Commodity traders took big advantage of the European central banks, and made a killing, essentially shorting the Euro just before it started to float. Now move this thinking to Moscow. Like, let's say that Russia demanded that buyers never be able to buy 100 rubles for less than a dollar. Well, if the ruble declined in relative value so that the floating exchange rate got to the point where a dollar was buying 101 rubles, then Russia would have to be buying back its own rubles, likely using “hard currencies” that it had accumulated from trading with other countries to do so. Russia would be hoping to constrain world supply, keeping its ruble prized at 100-to-1...at least against the US dollar.

And why would this matter?

Well, if Russia had to buy product using rubles from the U.S., which only took U.S. Dollars, and it couldn’t pay for those products in barter, i.e. things it owns tons of, like natural gas and lumber and, um...Russians...the more prized the ruble relative to the dollar, the cheaper those U.S. products would be to the Russian buyer.

A Chevy Bolt would go from costing $30,000 and 300,000 rubles to still costing $30,000, but only requiring 100,000 rubles were Mr. Putin to add this awesome car to his collection.

Okay, so how does all of this work at scale?

Like...it’s more than just being about some weird American with a fetish for zombies and nuclear waste wanting to do one transaction in the balmy green suburbs of Chernobyl. Why do we need to worry so much about foreign currency relative valuations anyway?

Because business does.

You like to eat, right? As in: French cheeses. Vodka. Caviar. That Swedish herring that makes people dry heave when they smell it. Well, it's likely you'll get a job in a business...and that business will be highly affected by the prices at which it exports its product, and the prices of the commodities it imports, often from overseas vendors—to build its product.

This currency exchange process is a huge part of the global economy.

Example time:

Consider you’re an American underwear seller, Barbara’s Boxers, doing business selling underwear to Latin American drug lords in the '90s, when the Colombian peso was inflating at about 1% a day. Yes, that’s right. Per day. Like...400 percent plus annualized.

You’d sell what was, at the time, 10,000 U.S. dollars worth of your NoGoCommando line to the Drug Lords. But then, if you were paid 30 days later...the bill was to be paid as 1 million pesos. And yes, we’re rounding exchange rates a lot here to make the math easy. So a month passes, and you actually get paid 1 million Colombian pesos. And yes, you are thankful to have been paid. You really didn't want to have to send the, um...guys with the baseball bats after the drug lords.Those bats always seem to disappear when the guys are sent home. But you were paid one million Colombian pesos 30 days later. That’s the good news.

The bad news is that the value of that million pesos…declined by a lot. The new value of those million pesos under 1 percent a day inflation? Well, it was a million divided by 1.01 to the 30th power...or a million over about 1.35. Or rather, that million dollars' buying power, 30 days later, was only 742,000 pesos' worth.

The 10,000 U.S. dollars’ worth of revenues you originally got from the sale ended up being more like $7,420 and change. And that’s a huge problem in the underwear industry, which is inherently low margin to begin with. And drops in purchasing power, or rather the negative effects of hyperinflation, take a company doing business profitably, to one…not doing business profitably.

So this transaction was a deal consummated with currency rates fully floating...likely with both the seller and the buyer knowing that there was massive inflation coming. The values of exchange were initially calculated on the spot, and that flavor of transaction is called a spot rate. It’s the simplest kind of transaction, and unfortunately, with no protection, ends up with your company going bust, or losing big money on the sale.

The kissing cousin to a spot rate is a forward transaction. In this structure, a deal is cut such that in n days or weeks or months or...whatevers, one party delivers a given value in a set currency. You could have said, “in 30 days, you will pay me $10,000 for this load of underwear.” That is, the drug lords would have been liable for the forward pricing of that product, and instead of the million Colombian pesos buying only 7,400 bucks and change, they would have had to have come up with something like 1.3 million pesos to then buy 10 thousand U.S. dollars and...pay their bill.

That way, in this example, the buyer bears the risk of the currency, not the seller.

The basic idea is that, since Bretton-Woods ended, foreign exchange is only and always will be a moving target, and in order to not be destroyed by transactions where the currency ratios go against you, you have to aim your arrows well in front of the direction the key currencies you care about are moving.

Especially when you, um…really care...