Currency Hedging Strategies for Canadians Investing in U.S. Stocks

Date: Tuesday, January 11, 2011
Author: Guest contribution provided by Forex Traders

Investing in foreign stocks inevitably carries certain risks besides the initial risk of the investment. One of the most important factors to consider when investing internationally is the currency or forex risk involved in the difference between the exchange rate when you first purchase the foreign currency to buy the stock and the exchange rate when you then sell the foreign currency once you decide to close out the stock position and repatriate your investment funds.

Having a foreign stock appreciate substantially, only to break even because of a similar depreciation in the foreign currency relative to your domestic currency, is a prospect that many international investors face constantly. Of course, if the foreign stock investment proves unprofitable, losses could increase with a falling foreign currency.

For example, although the Canadian Dollar is near historically high levels relative to the Greenback, recent forex news indicates that Canadians investing in U.S. stocks must still face the possibility of a falling U.S. Dollar that could significantly affect their investment bottom line.

Currency Hedging Principles for Stocks

In essence, the optimal hedging strategy for a Canadian to use to reduce the currency risk inherent in a U.S. stock investment will depend on where the USD/CAD exchange rate will be in the currency trading market when they close out their U.S. stock investment.

Therefore, establishing a market view or forecast for the future direction of the USD/CAD rate, perhaps using a combination of fundamental and technical analysis, will help considerably in selecting the most rewarding hedge strategy.

Furthermore, ideally, the time frame of any forex risk hedge under consideration should correspond appropriately to the investment time contemplated for the underlying U.S. stock asset.

Finally, the amount of your hedge should correspond roughly to the amount of your investment in the U.S. stock. Also, if dividends from the U.S. stock are substantial, a conservative investor may wish to consider protecting the currency risk on that cash flow as well.

Currency Hedge Examples Depending on Market View

Once the amount of hedge required, its time frame, and a market view have been established, an investor then will want to review the U.S. stock hedging options below to see which best fits their needs according to their currency forecast.

As an example, consider the situation of an investor wishing to purchase $1,000,000 of a U.S. stock, with an investment time horizon of six months.

If they expect USD/CAD to rise considerably, then this will favour the underlying long USD/CAD position inherent in their investment. With such a forecast, they could either remain fully or partially unhedged on the forex risk, or they could purchase a USD put/CAD call option with a $1,000,000 face amount as a form of insurance.

The strike price on this protective option could range from either At-the-Money (ATM) if they were less certain on their view or more conservative to Out-of-the-Money (OTM) if they were more certain or less conservative.

Alternatively, if they only have a limited positive view on USD/CAD, they could enter a range hedge where they would sell a covered OTM USD call/CAD put and buy an OTM USD put/CAD call option.

A neutral to negative view on USD/CAD would usually be hedged as fully as possible by selling USD/CAD forward in the OTM forex market or by buying CAD futures.

To read more on currency hedging, visit forextraders.com.