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Question: if you live in Canada but are paid in USD, how would you implement a hedging strategy to protect against currency fluctuations?

Can someone walk me through this? I have decent knowledge of options but have never actually worked through the practicalities of this.
 

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Depends on where you think the dollar is going and when you'll need to access you money. If the us economy recovers or raises interest rates then maybe the CND will fall down to .87, so in this case you should open a usd account and put your saving in there. Then again it way go up in the short term. crystal ball would help.
 

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For a single payment, this is fairly simple. Please note that unless one is receiving a large payment, it may not be practical to hedge the exposure at all because of the limitations of what banks or brokers are willing to offer.

Step 1: calculate the FX risk exposure and timing - for a single payment, this should be equal to the amount of the payment on the date that the payment is made

Step 2: determine what form of hedging one wishes to use (or whether to hedge at all)

Step 3: implement the hedging strategy

The two basic choices for hedging are futures/forwards and options. Futures or forwards hedge the exposure by offsetting it with an opposite exposure. For example, if you are exposed to risk relating to a rising Canadian dollar, you could offset this by selling US dollars (equivalent to buying Canadian dollars) in the forward market or by buying Canadian dollar currency futures. The cost of entering into a forward contract or trading currency futures should be relatively low. Options give one more flexibility. If exchange rates do not move as expected, you can choose note to exercise the option contract. Options are a costlier means of hedging since the option dealer demands a premium to provide what is effectively insurance.

Example of a futures-based hedging strategy:
Assumptions:
-The payment is US$100,000 on June 30.
-Canada-US spot exchange rate is at parity.
-Canadian and US short term risk-free interest rates are equal.
-The Canada-US futures contract implies that the exchange rate will also be at parity on June 30. The contract settles on June 30.
-The market does not expect a any change in the Canada-US exchange rate over the term of the futures contract. (This is a big assumption, but it is only important for the pricing of the futures contract. If there were a differential in short term interest rates, i.e. Canadian interest rates higher than US rates, the futures contract price would imply an appreciation in the Canadian dollar because of the arbitrage relationship between the spot rate, futures rate and interest rate differential.)

Step 1: The exposure has already been determined to be US$100,000 (C$100,000) on June 30.

Step 2: You choose to hedge the exposure using the CAD/USD June futures contract from the Chicago Mercantile Exchange.

Step 3: Through your bank or broker, you go long 1 contract (the contract size is C$100,000). You post the required margin of US $2,025 into the margin account. (You can find out how much margin you need to post from the CME website.)

From now until the contract settles, the Canada-US exchange fluctuates. For every US$0.00005 increase in the value of the Canadian dollar in US dollar terms, at the end of each trading day, US$5 is transferred to your margin account. If the Canadian dollar depreciates, the cash is removed from your margin account. During this time, you are required to keep a minimum margin of US$1,500. If the value of your margin account falls below this amount, your bank/broker requests that you top up the margin account back to US$2,025.

On June 30 when the contract settles, you can do two things:
1. Sell the futures contract (clearing out the margin account in the process) and exchange the USD to CAD in the spot market; or
2. Pay the USD to the counterparty through the exchange and take delivery of the CAD.
Regardless of which you choose, you should find that the total value of CAD you have in the end should be very close to $100,000.

I will give a rough overview of how to hedge using a currency option in a follow-up post. This is somewhat theoretical since I have never traded currency options. I did trade currency futures once, but not in the context that I have presented.
 

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Discussion Starter #4
This is great and I really appreciate you taking the time to write that out.

The specific context is I have a friend who is Canadian, but working (temporarily, on a two-year contract) in the U.S. She wants to hedge her paycheque.

I don't know how realistic this is for the relatively small sums and dispersed timeframes of a paycheque (i.e., she is paid every two weeks)...but what you've outlined is the bones of the process she'd need to follow.

Very interesting and gives me lots of food for thought.
 

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I've never attempted this but I understand the theory reasonably well. Forward techniques involve calculating a synthetic forward rate and borrowing in the proper currencies. Here's a theoretical example of how this all works:

Assumptions

  • Borrowing rate in Canada: k_domestic = 3%
  • Borrowing & discount rate in "foreign country X": k_foreign = 7%
  • Current (spot) exchange rate is: S = 0.35. (i.e., 1 CAD$ equals 0.35 in CountryXDollars, which I'll abbreviate as CX$ here.)
  • Let's say that the amount you want to hedge is an expected payment of 3.5 million CountryXDollars (CX$) in 1 year's time.
    • That is to say, you'll be paid 3.5 million CX$ in a year, and you want to create a hedge to ensure that, if the exchange rate goes down, you'll still make the equivalent (or more) in today's dollars.
Working thru it ...
The forward synthetic rate is calculated as:

Code:
F=((1+kdomestic)/(1+kforeign))*S = 0.3369
  • Expected future value in CX$: 3.5 million CX$
  • Present value: 3271028 CX$
  • Here's the trick: you borrow this present value amount right now in CX$ (at 'k_foreign').
  • Then you convert this amount (again, right now) to CAD$ to give: 1144860 CAD$
  • Now you invest it in Canada at 3%, to give a future value (in 1 year's time): 1,179,206 CAD$
  • In 1 year's time, you use your 3.5 million CX$ which you receive to pay off the loan.
Proving that this hedge works:
Forward rate of 0.32 =1179206/0.32 = 3,685,018 CX$
Forward rate of 0.31 =1179206/0.31 = 3,803,889 CX$
Forward rate of 0.30 =1179206/0.30 = 3,930,685 CX$

Thus, this hedge protects against the CX$ appreciating against the CAD$, by showing that if the actual forward rate is less than the synthetic forward rate, you will come out ahead.


Disclaimer:
This is a theoretical example; it establishes the basic premise of a currency hedge.

Sorry I can't be of much more help; I imagine that if I were trying to do this myself, I'd have to give some thought to the exact financial instruments that I'd employ in terms of how I go about the borrowing and investing.
 

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Discussion Starter #6
Ha! Dr. V; I work with financial models all the live-long day. That's the kind of model I would construct, too. I need to find someone who actually puts hedging strategies into place. :) Thanks! (I love equations and financial modelling.)
 

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this story doesn't quite add up. Someone working "in" the US will spend most of her paycheck (US spelling) on her US living expenses, unless she's a sports or music celeb earning $3 million a year. Assuming, though, that she's an ordinary citizen, any savings she might accumulate from that biweekly US paycheck could easily be exchanged into CAD if she wishes to keep CAD as her base currency. Meanwhile, canadian investments & savings could be left untouched, so that they may compound & rise. This in itself is an adequate simple hedge plan for the modest situation that has been described.

for intermittent currency exchange transactions with no fee, there are strategies derived from stock trading. Many investors utilize such a strategy. There are several recent threads about this useful approach here on cmf.

there are options. If she doesn't already do options, there would be no point introducing her to upp, udn & usx. "Hedging" the modest savings from a US paycheck, as the operation is described, does not lead to a sophisticated spread in upp, for example.

and taking up a typical 2-year work contract in the US does not lead to a $1 million currency hedge model. One has to wonder what is actually going on here.
 

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MoneyGal

Your friend could inquire with their bank to see if it offers currency forwards. The bank may require some high minimum threshold amount to exchange though, which might make hedging with forward contracts as impractical as any other means.

I hesitate to mention it, but aside from futures/forwards and options, there is one more method that comes to mind. There is an ETF listed in the US with ticker symbol FXC. I'm not exactly sure how it does it, but it is supposed to track the value of the Canadian dollar in US dollar terms. Theoretically one could hold enough units of this ETF long or short to hedge against a CAD/USD foreign exchange risk exposure. I'm not sure if it makes much sense for a Canadian investor/worker though.

On a related note, Dr_V has basically described covered interest rate parity. It explains the arbitrage relationship between the spot exchange rate, the forward exchange rate and the interest rate differential. Forward contracts work on the same principles as futures contracts, but they are not exchange traded and can be custom tailored to fit one's needs. Unfortunately, I would expect a bank to demand a minimum threshold amount for the value of the contract, so, as with the futures contract example I described, it probably wouldn't be practical for MoneyGal's friend.
 

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Thanks, Robillard.

Humble, there is nothing untoward. She is living in Toronto 3 weeks/month, spending one week/month in Michigan completing a post-doctoral fellowship. She stays in some kind of short-term accommodation (think student residence) for her 5 nights/month in the U.S., and travels back and forth by train.

The whole question is largely academic and mostly to satisfy my own curiosity. She asked me if there was a way to "protect" or "insure" herself against currency fluctuations and I wondered if there was some simple strategy which could be implemented. Sounds like the answer is "not really," especially for someone who is not a relatively sophisticated and informed investor.
 

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I faced the obverse of this situation when I moved to Canada and took my US-based job with me. Originally I continued to be paid in US dollars, but it became clear that this wouldn't work long-term since I wasn't planning to move back to the US.

Fortunately my firm has an office in Toronto so I got transferred there for paycheque purposes. So my "hedge" in this case was to simply switch currencies for my paycheque!

However, this still presents problems because when I moved here the Canadian dollar was worth about 80 cents US and now it's essentially at parity. This creates issues of salary equity (the change in the exchange rate means I now earn more than some people in my company who are considerably more senior than I), but it also creates issues for my clients, all of whom are in the US and must now pay a lot more per hour for my time (I work for a consulting firm). I usually end up billing for only about half the time that I actually work in order to preserve my clients' budgets and our competitiveness.

In retrospect, my salary probably should not have been smply converted to Canadian dollars at the outset but rather indexed to what it had been in US dollars. This would cause my salary in Canadian dollars to fluctuate, which would make things less predictable for me and possibly unworkable for our payroll department, but at least I wouldn't be priced out of the work I do (and like to do) best.
 

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what an interesting perspective in the commentary from brad. There's that famous yankee ingenuity in the adjustment to a half-time bill, so the US client can stay within budget & will remain a client. We are also seeing whole industries like forest products, that cost in CAD but sell in USD, cutting their prices to remain competitive.

i was going to say that modest run-of-the-mill currency dilemmas like the one MG posts are commonplace, if one includes the millions of canadians who receive, every single day, US earned income or US investment income or both. Do these small income earners hedge ? I don't believe so. My guess would be that they convert cash back & forth as the need or the opportunity arises.

all the more reason why those persons should learn how to convert USD & CAD with no currency exchange fee whatsoever, by pair-trading an interlisted canadian stock. I've done this for years. So, i noticed, has another senior poster on this forum. There are ancient message board chats about this strategy that date back nearly a decade. CC recently picked up the strategy & wrote about it on his blog.
 

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Question: if you live in Canada but are paid in USD, how would you implement a hedging strategy to protect against currency fluctuations?

Can someone walk me through this? I have decent knowledge of options but have never actually worked through the practicalities of this.
Try to get a USD mortgage? In all, try to hold as much of your debt as possible in USD, since the income to service it is also in USD. I imagine options would be an expensive hedge. CME has contract sizes of $100k CAD which is probably pretty large for an individual. Maybe use e-mini currency futures if such things exist for CAD:USD? That would likely be the lowest cost.
 

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I faced the obverse of this situation when I moved to Canada and took my US-based job with me. Originally I continued to be paid in US dollars, but it became clear that this wouldn't work long-term since I wasn't planning to move back to the US.

Fortunately my firm has an office in Toronto so I got transferred there for paycheque purposes. So my "hedge" in this case was to simply switch currencies for my paycheque!

However, this still presents problems because when I moved here the Canadian dollar was worth about 80 cents US and now it's essentially at parity. This creates issues of salary equity (the change in the exchange rate means I now earn more than some people in my company who are considerably more senior than I), but it also creates issues for my clients, all of whom are in the US and must now pay a lot more per hour for my time (I work for a consulting firm). I usually end up billing for only about half the time that I actually work in order to preserve my clients' budgets and our competitiveness.

In retrospect, my salary probably should not have been smply converted to Canadian dollars at the outset but rather indexed to what it had been in US dollars. This would cause my salary in Canadian dollars to fluctuate, which would make things less predictable for me and possibly unworkable for our payroll department, but at least I wouldn't be priced out of the work I do (and like to do) best.
If your CAD paycheque is indexed to USD fluctuations then you're really earning USD, pre-converted into CAD. You can have the hedge, or you can't. Can't have it both ways.
 
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