Understanding Currency Hedging
When the Canadian dollar fluctuates against foreign currencies, all Canadians are impacted one way or another. For instance, if you are buying a television from the U.S. and the Canadian dollar moves higher relative to the U.S. dollar, it will take fewer Canadian dollars to buy that television. If the Canadian dollar declines, then it will cost you more Canadian dollars to buy that same TV. This principle applies to any financial transaction or investment where foreign currency valuations are involved, including exchange traded funds (ETFs).
The change in value of a foreign currency relative to the Canadian dollar (referred to as currency risk or exchange rate risk) is an important factor to consider before investing in an ETF that invests in non-Canadian assets. For example, if the underlying investments of the ETF are bought in U.S. dollars (i.e., U.S. companies listed on a U.S. stock exchange), the appreciation or depreciation of the U.S. dollar against the Canadian dollar has the potential to either add or detract from the investment return.
Essentially, there are two options available to an investor: 1) be exposed to currency fluctuations (i.e., stay unhedged); or 2) be currency hedged. The objective of currency hedging is to reduce or eliminate the effects of foreign exchange movements over the life of the investment, such that a Canadian investor receives a return solely based on the change in value of the underlying assets, without the effect of changes in currency values.
Return on Foreign Assets +/- Change in Foreign Exchange Rate = Total Return on Investment
To reduce or eliminate the impact of changes in foreign exchange rates, ETFs that invest in non-Canadian assets are currency hedged.
How currency hedging works
To initiate the currency hedge, the ETF enters into an agreement with one or more investment dealers to sell the foreign currency forward (“forward agreement”). If the foreign currency drops in value relative to the Canadian dollar, the ETF will realize a gain in the value of the forward agreement, offsetting the foreign exchange loss. Alternately, if the foreign currency appreciates in value relative to the Canadian dollar, the ETF would realize a loss in the value of the forward agreement, offsetting the foreign exchange gain. In either case, the impact of the change in foreign exchange rate is eliminated.
Exchange rates vary over time
|Historic closing rate highs and lows, from 1950 to present||USD to CAD||CAD to USD|
|January 18, 2002||$1.6125||$0.6202|
|November 06, 2007||$0.9215||$1.0852|
Source: Bank of Canada
The Canadian dollar, in percentage terms, increased in value relative to the U.S. dollar by 75% from its low in 2002 to its highest point in 2007. An ETF whose investment mandate is currency hedged would avoid the negative effect of this dramatic change in relative value of the two currencies, while an ETF that remained unhedged would have been impacted negatively to the extent its investments were denominated in U.S. dollars.
Although the illustration above shows an extreme example of a change in exchange rates, the table below shows the year-over-year volatility of the Canadian-U.S. dollar exchange rate over time, which can also be significant over shorter periods of time. ETFs that employ a currency hedging strategy seek to eliminate all (or substantially reduce) the effects of foreign exchange rate changes.
Example: in December 2003, one U.S. dollar was equivalent to C$1.31 (or one Canadian dollar was equivalent to US$0.76). In December 2007, however, one U.S. dollar was equivalent to slightly more than C$1.00 (or C$1.00 was equivalent to almost US$1.00).
|Date||USD to CAD||CAD to USD|
Source: Bank of Canada, as at year-end
Should an investor currency hedge?
It’s important for investors to consider their appetite for currency exposure prior to investing in an ETF with a foreign investment mandate, rather than after they’ve owned it and have found themselves wondering why their experience is different than what they had expected (given the performance of the market). Some argue that over the long-term, currency fluctuations balance out, so there’s no need to hedge. Those who support currency hedging argue that most investors don’t hold an investment long enough to mitigate the effects of currency volatility.
|Concentrated||Portfolio diversification||Well diversified by currency|
|No opinion||View on exchange rates||Educated opinion|
Investors have choice
Investors can choose to take on foreign currency risk or not. Remaining unhedged may be appropriate for some but not for others. For individuals buying foreign stocks, employing a currency hedging strategy may be complex and cost-prohibitive. However, ETF investors looking to avoid the impact of currency fluctuations will benefit from ETFs that conveniently employ institutional hedging techniques on a cost-effective basis.
To learn more about currency hedging and investment products that can help you meet your currency hedging needs, please contact your investment advisor.