Using USX options to hedge U.S. dollar risk

With interest rates at historic lows, it is unlikely that the Bank of Canada will decide to raise the policy rate anytime soon. But we live in a world that is full of surprises, and things can change quickly. Events with the most unexpected repercussions can and do occur (the current pandemic comes to mind). Who really knows whether inflation will surge, forcing the Bank of Canada’s hand? If that were to happen and the U.S. Federal Reserve continued to hold rates at their current level, the value of the Canadian dollar could rise and, conversely, the value of the U.S. dollar would fall. This would have a negative impact on Canadians’ investments in U.S. dollars.

Hidden impact of currency risk on returns

Let us say that on January 2, 2014, two investors were looking to buy shares in ABC, a high-dividend stock. Should they buy their shares in the U.S. or Canada? ABC was listed at C$49.44/share on the Toronto Stock Exchange (ABC.TO) and US$46.29/share on the New York Stock Exchange (ABC.US), while the USD/CAD exchange rate stood at 1.0669. In other words, US$1,000 was worth C$1,066.90. Investor “A” bought 100 shares of ABC at C$49.44 in Toronto, for a total cost of C$4,944.00. Investor “B” bought 100 shares of ABC at US$46.29 in New York for a total cost of US$4,629.00.

As shown in Table 1 above, two years later (on December 31, 2015) shares purchased in Canada (ABC.TO) had generated a return of 9.71% in Canadian dollars, while the investment in the U.S. (ABC.US) posted a loss of 15.34% in U.S. dollars. However, if we take into account the exchange rate, which rose from 1.0669 to 1.3827 over the same period, we see that regardless of where they were purchased the securities have the same value in Canadian dollars, i.e. $54.24. In both cases, we obtain a profit of 9.71% in Canadian dollars instead of a loss of 15.34% in U.S. dollars. In this case, the apparent loss in U.S. dollars is actually a profit when converted into Canadian dollars. But the reverse is also true: if the exchange rate had gone down instead of up, then a profit in U.S. dollars could have turned into a loss in Canadian dollars.

Now we will return to our example, this time using a falling exchange rate.

As Table 2 shows, the U.S. dollar investment generated a profit of 22.03%, which is somewhat misleading because when we take the exchange rate into consideration, we are actually talking about a loss of 8.50%. So when we make investments in U.S. dollars, if we want the true picture we must always take into account any change in the exchange rate between Canadian and U.S. dollars.

USX options

The Montréal Exchange offers investors the chance to hedge their foreign exchange risk with options on the U.S. dollar. They are called USX options, and each contract is for US$10,000. USX options are European-style, meaning that they can only be exercised at expiration. Final settlement is in cash, in Canadian dollars, and they are quoted in cents Canadian. For example, a quote of 1.25 cents Canadian equals C$0.0125, such that each contract has a value of C$125 (C$0.0125 × 10,000).

Using USX options to hedge currency risk

An investor wants to buy U.S. stocks in her RRSP. She converts C$135,350 into US$100,000 at a USD/CAD rate of 1.3535 and uses the U.S. dollars to buy U.S. stocks. She is concerned that the Bank of Canada may soon announce an interest rate hike, which could cause the U.S. dollar to depreciate, so she considers buying USX put options to hedge the risk that the U.S. dollar will fall below 1.35. She therefore buys 10 contracts (10 × US$10,000 per contract = US$100,000) of put options with a strike price of 135 (equal to a rate of 1.35). They are priced at 0.80 cents Canadian (C$0.0080), for a total cost of C$800 (10 × C$10,000 × C$0.0080). With this position she has set a floor of 135 (a rate of 1.35).

The Bank of Canada holds its policy rate-setting meeting and decides to raise key interest rates. As a result, the USD/CAD rate begins to fall. Finally, it stabilizes at 1.30, equal to 130 cents Canadian.

As Table 3 shows, hedging with USX put options generated a total profit of C$4,200. When the position was taken, the investor’s US$100,000 at an exchange rate of 1.3535 was worth C$135,350, while at expiration of the put options, with an exchange rate of 1.3000, they were worth C$130,000. This represents a loss of C$5,350 (C$135,350 – C$130,000). As a result, the C$4,200 profit on the put position serves to partially offset the C$5,350 loss. The investor has therefore managed to use put options to set a floor of 135, since any drop below this level will be offset by an increase in the value of her USX put options.

Note that USX options are not only tools for hedging foreign exchange risk. All strategies commonly used by investors in the equity options market work in the same way with USX options. For example, an investor who expects the exchange rate to go up can take advantage of this by purchasing USX call options. For more information on USX options, go to: https://app.tmx.com/usx/

Before you start using the strategies mentioned in this article, we suggest that you test them using the Montréal Exchange’s trading simulator.

In addition, if you would like to learn more, we invite you to register for the webinar “Une couverture contre le risque de change lié au dollar américain à l’aide des options USX,” to be held on August 13, 2020 in collaboration with Desjardins Online Brokerage.

Good luck with your trading, and have a good week!

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.