Impact of the Exchange Rate on Our Investments in the United States

Given our proximity to the United States and/or for purposes of geographic diversification, many investors have investments in their portfolios that are priced in U.S. dollars. As with all investments, U.S. equities carry market risk, and it is important to carefully analyze securities so as to minimize, as much as possible, the number of poor selections added to a portfolio. However, even if investors select the best available securities and optimally diversify their portfolios of U.S. securities, they will still be exposed to the risk of the U.S. dollar fluctuating against the Canadian dollar. This risk can have a significant impact on total return when it comes time to sell the securities.

What is currency risk for an investor?

For an investor, currency risk arises from the difference between the exchange rate paid at the time the securities were purchased and that received when they are sold. For example, consider the investor who buys 1,000 units of SPDR® S&P® 500 (SPY), an exchange traded fund (ETF), at US$300 per unit, for a total value of US$300,000. The units are bought at a time when the USD/CAD exchange rate is 1.32. This means that the investor will have to pay CAN$396,000 (US$300,000×CAN$1.32/US$) to acquire the 1,000 units of SPY. By the time the position is liquidated, the exchange rate may be the same, but it may also have increased or decreased. The following table shows different outcomes following an increase or decrease in the exchange rate, assuming an unchanged unit price for SPY.

Table 1: Results following fluctuations in the USD/CAD exchange rate, with the price of SPY unchanged

The above table shows the risk faced by an investor from a decrease in the value of the U.S. dollar, since he will receive fewer Canadian dollars for his 1,000 units of SPY, even though they have been resold at the same price in U.S. dollars.

What can be done to protect a position against this risk?

Fortunately, the Montréal Exchange offers options on the U.S. dollar (USX)^[1] that investors can use as a hedge against their currency risk. Each USX option contract is for US$10,000, and premiums are quoted in Canadian cents per U.S. dollar. So the investor could have purchased 30 USX put option contracts (US$300,000 ÷ US$10,000/contract) to hedge against a decrease in the USD/CAD exchange rate.

Example of a Hedge Using USX Options

Imagine an investor who decides to buy, on October 30, 2019, 1,000 units of the SPY ETF, trading at US$304.14 at the close of business, for a total amount of US$304,140. At that time the US$/CAN$ exchange rate is 1.3154^[2]. As a result, he will need to pay CAN$400,065.76 to acquire the units in U.S. dollars. As we saw above, the risk in such a position is that the value of the U.S. dollar will fall, so the investor will need to buy enough put options to obtain sufficient protection against this risk.

There are several ways to calculate the number of contracts the investor will need to purchase as a hedge on this position. One of the simplest ways is to divide the value of the units by the size of the option contract and round the result to the nearest integer. This means that the investor will need to purchase 30 put option contracts (US$304,140 ÷ $10,000) to adequately hedge her currency risk. She could choose at-the-money options (i.e. options with an exercise price that is almost equal to the current exchange rate), but in this case the investor is prepared to assume at least some currency risk: no more than 2%.

So, at an exchange rate of 1.3154, she would need to buy out-of-the-money USX put options at a rate near 1.2891 (1.3154 × (100% – 2%) = 1.2891).

The investor has certain financial obligations and knows that, if she is to meet them, she will need to close out her position in June 2020. So she decides to purchase 30 USX put option contracts expiring on June 19, 2020 with an exercise price of 129 Canadian cents, listed at 1.16 cents Canadian per U.S. dollar, for a total of CAN$3,480 (30 contracts × CAN$0.0116 × US$10,000).

Table 2: Results from the hedge, based on various exchange rates as at June 19, 2020 and an unchanged price for SPY

As the above table shows, the investor is protected against a drop in the exchange rate but will benefit if it increases. This is because the minimum value of the portfolio can fall as low as approximately CAN$388,700 if the U.S. dollar trades at below 1.29. On the other hand, the value of the investor’s portfolio increases when the exchange rate rises above that level.

This example only took into account changes in the exchange rate; the value of SPY units was unchanged. In reality, by the time the investor closes out her position on June 19, 2020, the value of the SPY shares will likely have changed, for better or for worse. So the position taken by the investor in USX put options is solely a hedge against currency risk and in no way will it protect her from market risk. In order to hedge against market risk, the investor would need to purchase put options on the SPY units.

Please note that USX options are not used solely to hedge currency risk. All the strategies typically used by investors in the equity options market can be used in the same way with USX options. This means that an investor who expects the exchange rate to go up can take advantage of this hunch by buying USX call options. For more information on USX options, see: https://app.tmx.com/usx/

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

^[1] Source: Montréal Exchange, (https://m-x.ca/produits_options_devises_en.php)

^[2] Source : TC2000, Worden Brothers, Inc.

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.