How to Hedge Foreign Currency

A Canadian owning U.S. assets is exposed not only to the performance risk of the asset, but also to exchange rate risk. You must make two separate decisions: to buy the stock or not, and to hedge the FX or not. The tax treatment of exchange rate gains and losses (for Canadian tax) is covered by Interpretation Bulletin IT-95. You can find the rates at the Bank of Canada site.

Excuses and Lies for Not Hedging

1. “Retail Investors cannot hedge.” This is presented by the industry that WILL not let you hedge. There is a difference between ‘cannot’ and ‘will not’. The industry denies everyone (except ‘qualified investors’ who are worth $1,000,000 with income of $100,000) access to the futures market, where a year’s hedge can be bought for $3. Your response should be to lie to the brokerages. Claim you are ‘qualified’ and use these restricted products yourself.
2. “I don’t know how” has been offered up on national TV by portfolio managers with seven-digit salaries. Bald-faced lies.
3. “Hedging involves speculating on exchange rates.” This qualifies as being ‘unclear on the concept’. When your position is hedged, by definition, all exchange movements will have NO impact whatsoever. Derivative products can be used to EITHER increase risk (leverage) OR to decrease risk (hedge). You are speculating on FX when you are NOT hedged.
4. “Futures contracts are highly leveraged, so using them to hedge is very risky.” First consider whether your existing exposure to FX is leveraged. When a Canadian spends $100,000 buying US stocks, how much money is invested in the stocks, and how much in the US currency? In fact ALL your investment went to buy the stock. Your resulting exposure to the US$ is 100% leveraged. Putting a hedge in place offsets your leverage; neutralizes your leverage.
5. “It all evens out over time.” Look at this 80-year chart. There is no cyclical repeating pattern. To presume that the Loonie will revisit $0.62, just because it hit there once, is wishful thinking. When 15 big currencies are charted over 1900-2000 (ref:Optimists) it is clear that currencies
   • make large one-time movements that never ‘correct’,move randomly in a range, ortrend steadily in one direction for a generation or two.
6. “I made money on the falling loonie so I don’t mind losing money as it strengthens.” These people don’t understand that investing is about making money AND KEEPING IT.
7. “I buy US positions in my Cdn $ account”; or “I buy Cdn interlisted companies”; or “I use ETFs trading on the Cdn exchange.” The error here is mistaking the appearance for reality. It is the business’ operations (purchases/sales and assets/liabilities) that create the exchange risk. It does not go away when the company reports in another currency, or lists on another exchange, or when the investor uses another currency to purchase the shares.
8. “It is too expensive to hedge.” The fund managers who say this are referring to using options to hedge. This method IS expensive but not the only method. The cost to buy a futures contract good for a year, is about $5. Pittance. Yes you must provide collateral but that is not a cost.You will also find that buried somewhere in whatever method you chose, is a cost/benefit equal to the difference in interest rates between the countries. Since Canada and US rates are so close you can cancel out any cost by using limit orders that let normal market volatility make up the difference.The cash funding of open futures contracts come from the daily settlements. If your position gains $1,000 in value one day, there will be $1,000 put into your account. More importantly, if your position loses $1,000, it will be taken from your account. If there is not sufficient cash your broker will consider it borrowed and charge you interest. You must realize that because this is a hedge, you are not ‘losing’ that cash. For every dollar you might lose in the futures account, the offsetting investment in the foreign security will have gained the same amount. Agreed, you cannot liquidate that cash daily, but the value is there.
9. “But what if the Loonie goes back down?” This is the same mind space of investors who refused to sell as Nortel’s stock fell from its highs. They had already suffered so much pain that they could not abide the thought of selling, only to see the stock go back up. They preferred the possibility of continuing to lose money to the certainty of not recovering money already lost. Investors must realize that past losses do NOT make future gains more likely. The past is done and gone. Only the future should be considered.
10. Different countries’ currencies move in different directions. Losses from one currency will be offset by gains in another. In fact, the 101 year chart of 16 currencies (ref:”Optimists” p92) shows that only the Swiss and Netherlands gained against the US dollar and Loonie. Canadians and Americans would have lost from holding all the others.
11. Exchange losses are minimal if diversified. From data in “Optimists p93”, Americans invested in an equally weighted basket of 16 currencies would have lost 87% over 101 years from currency translation. Since the Loonie held very strong against the US dollar, Canadians too, would have realized this loss.
12. Diversification is good therefore diversification of currencies is good. This argument misrepresents what diversification of investment securities accomplishes. Even while you presume all your investment securities will increase in value over time, not all will go up at the same time. Diversification of securities smoothes the volatility of your portfolio’s value and makes sure you do not mis-pick only losers.But no one expects currencies’ exchange rates to increase over time. Currencies are NOT investment securities. The exchange rates vary in both directions. Only FX traders buy currencies with the objective of making money. You are investing in the company, not the currency. Exposing yourself to another currency increases, not decreases, your risk. Increasing the number of currencies you are exposed to increases the point-source of your FX risk, it does not reduce your risk.
13. Over the long run real exchange rates tend to be relatively stable. This is the argument used by “Optimists“, p104. Their conclusion was reached after a decision to ignore 90% of all exchange movements. That decision is preposterous. Their argument is “we are measuring real returns (after inflation), therefore all the exchange rate changes caused by differing rates of inflation between countries should be ignored”.Their excuse is bad, bad logic. Evaluating foreign investments requires a specific country’s point of view. Only the home country’s inflation matters. First, the indexes of foreign markets should be measured – giving the equity return. Then, those values are translated into the home country’s currency – giving the return for both the equity plus the currency. Only then should the results be discounted for the home country’s inflation.
14. You can protect yourself from home-country inflation by diversifying in other currencies. The argument is that inflation will devalue your currency, so holding other currencies will protect you. While it is technically correct that purchasing power is the prime determinant of exchange rates, this effect shows only in the long-run. In the short-term, inflation may cause a rise in the interest rates, causing the currency to RISE due to the inflow of capital from carry traders .Also consider that inflation rates are much more globalized now than in the past, especially between large economies. When you are facing inflation, chances are your neighbour is too. Also consider that (using this argument) currency diversification leaves you at risk from the other country’s inflation. Inflation grows when an economy is smoking hot – just when you will want to be invested in its companies.

Why Not Hedge ?

1. If you are pretty sure the exchange rate will not change more than a percent or two, it is reasonable to save yourself the hassle.
2. If you think the rate change will work to your benefit, AND YOU HONESTLY ACKNOWLEDGE YOU ARE SPECULATING, you would feel that hedging is an unnecessary restriction on your profits.
3. If the only methods of hedging available to you were more costly than your expected FX loss, you would not hedge.
4. Before making this decision use this FX charting service (Pacific Exchange Rate Service) to get a clear idea of short and long term exchange movements.

HOW? … To Hedge a U.S.$ Asset Create a U.S.$ Liability

1. Borrow US dollars from your broker. Canadian banks will not lend you US dollars. You should complain. The Government borrows US dollars. The bank themselves borrow US dollars. Our businesses can borrow US dollars. But retail Canadians can’t.In 2003 US margin was dirt-cheap, and again in 2009 some brokers charge less than 1%. This method is preferable to buying Futures contracts when there is risk that the Loonie may fall in value for any extended period in which you would have to fund the loss from a futures contract. But when US borrowing rates rise, this strategy ends. The proceeds must be invested in Canadian assets.
   • You can buy the Loonie currency ETF (e.g. N-FXC) when you are less sure of a leveraged play. Or you can create a ‘carry trade’ by
     1. buying Canadian companies dual listed on US exchanges.
     2. buying a Canadian market index ETF from a US exchange that Americans would normally buy.
     3. repatriating the cash into Loonies in order to buy a wider variety of Canadian assets. (You will be charged FX exchange fees (about 1.5%) each way.)
2. If you own real estate in the US, take out a US dollar mortgage there. Move the money into Loonies to pay off Canadian debt or invest.
3. If you own US index ETFs (e.g. Spyder (SPY) or Dow (DIA)) consider instead buying the Future Contract of that index instead. At the end of the contract you would have to pay for it in US dollars. In other words you have created a US liability. Futures contract cost next to nothing to purchase. If they gain in value, the profit $$ will be deposited in your account. No one objects to that. But the reverse is also true. If the contract loses value, the $$ loss will be withdrawn, daily, from your account. This is much the same process as most brokers use for short selling stocks.The future’s market price starts with the current index value, reduces it for the dividends you will not receive, and increases it for the bank interest you will earn by keeping your cash until the contract’s end. A Canadian keeping his $$ in Loonies will earn a different interest rate, so the cost of the hedge includes the interest rate differential between the countries. It has been only a very small percentage for a long time.
4. It is more simple to buy the hedged ETF products (S&P, EAFE) available on the Toronto Exchange. These products buy the futures of the index (as above in 3). Warning! What you think you are getting in the hedged non-US indexes (e.g. EAFE) may be different in reality. Some hedge the home currencies of the underlying companies to the Loonie. Those hedges would not be US$/Loonie hedges. You would NOT get the same rate of return as an American buying the original index.
5. If you own individual US stocks, BUY a Futures contract on the Canadian Dollar. As with Index Futures above, this creates a US dollar liability. These are valued at CAN$100,000 so you may have to share with a friend. The gains/losses on these contracts are treated as ‘capital’ for Canadian tax purposes – only 1/2 taxable (IT-346R). As discussed above, the contracts are essentially free, and the cash value of gain/losses with be credited/debited to/from your account daily.There are also mini-contracts worth only US$10,000 that make this strategy more accessible to small investors. There may be much less trading on these contracts, so watch the pricing. Notice that these contracts are reversed from the large contracts. These are “to buy US dollars and to be paid for in Loonies at the end of the contract”. So to create a US dollar liability you would SHORT this contract.
6. There is a brokerage, CMC Markets, that allows you to create FX positions which will hedge the currency exposure of your stocks. They charge no commission on FX trades, and collect their income from the bid/ask spreads, and the interest earned on long overnight positions and the collateral. The spreads are quite small and you can avoid the interest charged on overnight positions by picking the contracts that allow you to ‘short’. While the collateral required for normal FX futures contracts can be invested in productive assets, here it is cash. Your ‘cost’ is the income forgone on that collateral. Even though their stated requirement is only 1% collateral, you must also fund the changes in value. So in order to maintain the hedge, your collateral must be more like 5%.
7. There are now ETF products that invest in specific currencies (list). Some people say Canadians can use these to hedge. NOT exactly.If you buy the ETFs you are using some of your principal. Hedges only work if they cost nothing. So buying the Loonie ETF with US dollars, when you are a Canadian, accomplishes nothing that simply repatriating your cash wouldn’t do. (Granted these have lower transaction costs.) However, buying the (e.g.) N-FXC Loonie ETF on US dollar margin creates the US dollar liability that will hedge any US dollar holdings.Shorting these ETFs should be considered because then no principal is required. You must cover the cost of the ETF’s distributions, so the interest rate differential comes into play. For example, if a Canadian owns Euro denominated assets, he may want to short the Euro ETF. The problem with this is that the process of shortselling deposits US dollars into your broker account. So while the Euro gets hedged, you now have US dollars NOT hedged. You could withdraw the proceeds from the short sale and repatriate them to Loonies, but your broker would charge interest on the money withdrawn and the repatriation will cost another 1.5%.But if you are an American, shorting these ETFs DOES work. If you are invested in Canadian companies but do not want exposure to the Loonie, you short an equal dollar value of the Loonie ETF.These products DO work to fine tune a futures contract hedge. Say a Canadian’s US portfolio was worth $100,000 when he put a $100,000 hedge in place. If the stocks decline in value 10%, he will no longer want 10% of the hedge. Since the futures contracts are for large denominations he cannot fine tune with them. Instead, he short sells $10,000 of the Loonie ETF. It has the effect of depositing US dollars into his account; thereby providing the full offset to the futures contract. With the combination of the ETF and futures contract he now has zero US dollar exposure, and is long $90,000 Loonies (assuming the currencies were at par throughout).
8. Buying an Option on the Can$ will somewhat hedge your US exposure. Options cost about 1% a month, and you have to correctly predict both the time frame and rate movements to have it pay off. It will never be a perfect hedge. It will not increase/decrease $1 for every $1 your investments decrease/increase in value. Rather, it will be ‘negatively correlated’ to the FX gains/losses you are trying to hedge. It will tend to move (in value) in the opposite direction, but will never offset 1:1.You can also buy options on individual stocks. If you buy the issue far into the money, you will pay only the intrinsic value (say 15%). The rest will be hedged if you keep the remaining money in your home currency. See the discussion on Leverage in Options
9. Forward Contracts are a better variant to the Future Contract, but are not available to us. Your company may have access, so make nice to the comptroller, and ask. Know what you are talking about first though. There is a very good article on the difference somewhere on the CME website.

Where Do I Look For Currency Problems ?

1. The registered or head office location of a company can be Canada, US or elsewhere. The currency of these locations will not cause FX gains/losses.
2. The stock exchange used to list the shares will not impact FX. Buying Alcan on a US exchange will not expose you to $US FX risk. Buying Saputo on a Canadian exchange will not save you from FX risk from its US operations.
3. A company can report their financials in any currency they like without affecting the reality of its FX gains/losses experienced. But the currency used will determine the reported measure of the gain/loss. It is no surprise that many Canadian companies with US operations changed their reporting to US$ in 2003-2004 to hide the devastating effect of the 30% FX loss.
4. Buying foreign (non US) index ETFs and ADRs listed in the US (e.g. EAFE) will not expose the investor to $US-Loonie FX risk. The US dollar is just a convenient intermediator. Think of it like a Turk and a Mexican talking to each other in English. The investor is exposed to the FX risk of the specific country vs Loonie, if that is where their operations are. But most of these indexes and ADR companies will be very large internationals with 50% of operations in the US. To that extent, owning them will expose you to $US-Loonie FX risk.Just to make things complicated: If what you want is to earn (as a Canadian in Loonies) the same return as the posted return (in $US) for the (e.g. European) index, then you must hedge the $US-Loonie FX. This will still leave you exposed to the $US-Euro, but so is the index. Similarly with an ADR. If you hedge the $US-Loonie then your return is the same as the ADR’s, but not the return of the stock on its home exchange.
5. A company’s operations and assets are where to look for FX exposure problems. The currencies of these countries will give rise to FX effects. E.g. SinoForest (T-TRE) is listed in Canada and reports in $US, but it is the Chinese currency of its operations that will cause the currency gains/losses against the Loonie.

Buy U.S. Stocks Now While The Dollar Is On Sale … FALSE

It was common to hear this advice in 2007-2008. The Loonie had increased in value against the dollar about 50% over the prior few years. So the Loonie bought more US shares than before. But that does not mean you got more value than before.

When you buy a consumable whose use is measured in pleasure, the stronger Loonie allows you to buy “more” enjoyment than in the past. E.g. you can buy a longer vacation in Florida. It costs less now to get the same amount of pleasure. It is correct: Now is the time to buy “with the dollar on sale”.

But this is not the way to approach the purchase of investments. With investments, you are not so interested in buying the ‘asset’, as you are interested in buying ‘income’. That income is denominated in the same foreign currency. A stronger Loonie lets you buy more shares of US companies. But the larger dividends shrink proportionally when converted back to Loonies. Their shrinkage completely offsets the increased number of shares you bought. Net zero change.No matter how strong the Loonie gets, the value of the income in Loonies, will be discounted by exactly the same rate that the cost of the assets was discounted. At all exchange rates the ‘rate of return’ will not change. A 10% yield in US dollars from a US asset will earn a Canadian that same 10% when purchased with Loonies.

The exchange rate movements of the past created currency gains/losses – also in the past. They have not made investments ‘cheaper’. The concept of buying stocks ‘cheap’ implies a higher rate of return. E.g. buying stocks with a low P/E results in a larger earnings yield (E/P). But the strengthening Loonie has impacted both the cost AND the earnings of investments equally. The ‘rate of return’ remains the same.

This argument is different from the argument, often made at the same time, that now is the time to buy US dollars because “exchange rates are cyclical and the Loonie is bound to retrace its gains”. See the graph above to prove this argument wrong also. Just because the Loonie hit $0.62 once does not mean it will ever go there again.

How Do I Understand the FX Reported in Financial Statements ?

First consider revenue and expenses. These are not a problem. The operating results from another country are translated into the reporting currency at the average FX rate over the period. Granted, the investor is forward looking, and would like them translated at the most recent FX rate, but the average rate is disclosed in the notes, and he can make his own assumptions about the future. Most businesses consider it good management to match revenues from a country with costs from that same country, so that the FX risk is limited to the profit margin. It should be obvious to the investor when this is NOT the case: such as mining or oil operations.

The problem lies in the translation of the value of foreign assets and debts. The FX translation effects are reported in three ways.

1. Sometimes the change in FX value will be in the Income Statement, sometimes individually disclosed, sometimes not.
2. Sometimes the change in FX bypasses the Income Statement and gets posted directly to the Balance Sheet’s Equity, in the account called “Cumulative Translation”. You can measure this by subtracting the difference between the opening and closing values.
3. Sometimes the change in FX is not reported or measured anywhere – until the asset is eventually sold. There is nothing you can do about this because you will not have the necessary information.

Managements often say they have hedged their foreign assets with offsetting foreign debt. Even where this is true, the reporting of the FX effects may show up in different places. There is nothing an investor can do except measure what is available to be measured, and make sure it is all included in comprehensive earnings.

There are two arguments made for NOT including FX changes in the Income Statement.

1. When the financials are used to evaluate management it is not appropriate to make management responsible for investors who live around the world. But for the investor the issue of evaluating operations managers is minor.
2. When the foreign operations are considered permanent, with no expected repatriation. Why worry about a write down that may never occur? But the presumption that there will be no repatriation is not valid. Expansions into specific countries often flop, with the assets withdrawn. Divisions are often sold, with the proceeds redirected around the world. The US tax amnesty of 2004 prompted millions of dollars to be repatriated from abroad. Even that condo in Florida will probably be sold to fund retirement home costs in Canada.

Their arguments are not consistent.

1. Everyone agrees that all debts should be revalued to the current exchange rate, so why not all assets? Not revaluing assets reflects only the accountants’ attachment to historical cost accounting.
2. People that agrees with the revaluation of some Balance Sheet items still object to recognizing the change in value as Income. But Income is defined as ‘the change in value’. You cannot both accept the Balance Sheet change AND reject its recognition as Income. Their position is the same as an investor who measures the value of his stock portfolio in his home currency, but measures his portfolio gains in a mix of foreign currencies.

Investors should be able to see both the operating results and the FX translation effects separately, so they can project the future, separately, of both the operations and exchange rates. Unfortunately, the reported information is not enough to make these two evaluations.