How Currency Hedging Works
Although the effect of currency fluctuations diminishes over
time, there are ways to mitigate the impact of exchange rates in
the short term. This process is known as currency hedging. Regardless of how
much the Canadian dollar moves after hedging, investors know that
there will be limited impact on investment performance due to
currency movements.
Hedging Example:
A classic example of hedging involves a farmer who sells his
wheat to food producers. Each growing season, the farmer knows how
much wheat he will produce long before it is harvested a few months
later. What he is less certain of, however, is what wheat prices
will be once the crop is harvested and sold to food producers. If
wheat prices rise, the farmer benefits, but if prices decline, the
farmer earns less money.
To protect against this uncertainty, the farmer can enter into
an agreement early in the growing season to lock in a fixed price
for the wheat he will harvest and sell in a few months time. By
locking in a fixed price for his wheat, the farmer will know how
much he will earn for his crop and will not have to worry about
fluctuating market prices. This process of mitigating risk resulting
from fluctuating prices is known as hedging.
Currency hedging has drawbacks as well
The primary drawback of hedging is that if the Canadian dollar
falls relative to a foreign currency, the opportunity for higher
returns based on exchange rate movement is lost. The upside is that the
investment is protected against a rise in the value of the Canadian
dollar relative to foreign currencies.
Similar to an insurance policy, the objective of hedging is to
remove uncertainty. But just like there's a cost to purchase an
insurance policy, there's typically a cost to enter into a hedging agreement.
Fortunately, these costs are minimal within solutions such as mutual
funds given their large size and professional guidance.
The impact of currency hedging: short-term versus long-term
While a rising Canadian dollar has negatively impacted returns on
U.S. investments in recent years, the opposite effect was seen throughout
most of the 1990s. During this time, the U.S. dollar increased relative
to the Canadian dollar. As a result, many Canadians received a boost
in the value of U.S.-based investments when converted back to Canadian
dollars.
Although the impact of currency will vary in the short term, the
impact over time is minimal. The charts above highlight both the impact
of exchange rate movements from year to year and how over time these
fluctuations tend to offset one another.
Learn more about the impact of currency movements and exchange rates on your investments:
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