Hedging of foreign currency exposure: To do or not to do?
As the Canadian Dollar hits parity with the U.S. dollar, more investors and newspapers are talking about currency hedging. An example of currency hedging is when a Canadian investor who invested in say the U.S. market is concerned that her U.S. dollar returns will be reduced, eliminated or turn into a loss due to potential appreciation of the Canadian relative to the U.S. dollar. Hedging against such an event can be done by selling futures contract in U.S. dollars of value equal to the expected market value of the U.S. investment at a particular time, for a pre-agreed exchange rate. Such contracts are available on futures markets. This way you can (almost) get in Canadian dollars, the returns that would be available on your U.S. investments. There is an easier way of implementing this if you wanted to invest say in U.S. or EAFE indexes, as these are available already hedged back into Canadian dollars as ETFs from Barclays. Many mutual funds are also available in hedged form.
But talking about the hedging, after the dollar appreciated in value over 60% over the last six or so years, with exchange rate moving from US$0.62/CAD to parity, feels a little like closing the barn door after all the horses left; though I am not advocating that you should or should not hedge your foreign currency investments, as I am not a fortuneteller. What I want to discuss is why and how people manage this risk.
Historically short-term currency direction is considered highly unpredictable, though long-term exchange rates rarely go only in one direction. Just as in the case of the Canadian dollar. It was at, and above, par with the U.S. dollar in the 70’s; then about six or so years ago, there were concerns that the then $0.62/CAD was heading to $0.50/CAD.
Investing in different countries is a form of diversification. In a situation when the countries also happen to have different currencies, that adds an extra dimension to the diversification. So from the portfolio standpoint there is considerable debate among investment professionals about the appropriateness and the extent of hedging the currency, and therefore the return, exposure associated with foreign investments. Some suggest no hedging (i.e. using currency as a form of diversification- which is what I have been doing and not planning to change it at this time), others suggest fully hedged positions back into home currency, whereas still others suggest splitting the difference (i.e. perhaps hedging about 50% of the foreign currency exposure). Typically, your hedging, if any, would be focused on the U.S. dollar exposure, as that would normally constitute the largest currency exposure for a Canadian investor’s portfolio.
Clearly you should think of hedging as insurance (risk reduction) rather than speculation. In fact the way I think about this is in terms of where I am going to spend my money. So, for example, if I spend 4-5 months in the U.S. each year, and thus about 30-40% of my expenses are in U.S. dollars, then why try to guess the direction of the exchange rate; instead, as part of my target asset allocation, 30-40% of my assets are allocated to U.S. denominated/correlated assets, approximately matching the ratio of my US$ expense exposure. So when my Canadian dollar returns on my U.S. investments are attenuated by an appreciation of the Canadian dollar, my pain is also attenuated by my (lower in Canadian dollars) corresponding U.S dollar expenses. Of course, when the exchange rates change direction, the pain and joy will still be there, but this time because the U.S. returns will be higher but so will the expenses when measured in Canadian dollars.