Hedging Exchange Risk

Forward rates can be very useful as a tool for hedging exchange risk. The caveat is that a forward contract is highly inflexible, because it is a binding contract that the buyer and seller are obligated to execute at the agreed-upon rate.

Understanding exchange risk is an increasingly worthwhile exercise in a world where the best investment opportunities may lie overseas. Consider a U.S. investor who had the foresight to invest in the Canadian equity market at the beginning of 2002. Total returns from Canada’s benchmark S&P/TSX equity index from 2002 to August 2008 were 106%, or about 11.5% annually. Compare that performance with that of the S&P 500, which has provided returns of only 26% over that period, or 3.5% annually.

Here’s the kicker. Because currency moves can magnify investment returns, a U.S. investor invested in the S&P/TSX at the start of 2002 would have had total returns (in terms of USD) of 208% by August 2008, or 18.4% annually. The Canadian dollar’s appreciation against the U.S. dollar over that time frame turned healthy returns into spectacular ones.

Of course, at the beginning of 2002, with the Canadian dollar heading for a record low against the U.S. dollar, some U.S. investors may have felt the need to hedge their exchange risk. In that case, if they had been fully hedged over the period mentioned above, they would have foregone the additional 102% gains arising from the Canadian dollar’s appreciation. With the benefit of hindsight, the prudent move in this case would have been to not hedge the exchange risk.

However, it is an altogether different story for Canadian investors invested in the U.S. equity market. In this case, the 26% returns provided by the S&P 500 from 2002 to August 2008 would have turned to negative 16%, due to the U.S. dollar’s depreciation against the Canadian dollar. Hedging exchange risk (again, with the benefit of hindsight) in this case would have mitigated at least part of that dismal performance.