How to hedge CDN$

[Cardboard]

I don't have a brokerage account to trade futures so it took me a while to figure this out. After successful testing, I decided to pass this along which may be helpful to some of you who want to eliminate the USD/CAD$ variation on their U.S. holdings.

 

Basically, what I have done is to buy put options on the U.S. dollar on the Montreal Exchange (www.m-x.ca) at the current exchange rate (today it would be the USX symbol with a strike price of 106) and to immediately sell the same call. Each contract represents $10,000 U.S. At the moment, you can hedge as far as June 2010.

 

The way I have done it, it basically locks the exchange rate at the current rate at almost $0 cost to me with the call writing paying for the put. You will find that there is a tiny cost due to the buying of one and selling of the other with the bid/ask spread, but again it is tiny relative to the protection offered. I never use options from the Montreal Exchange or TMX since they are highly illiquid making the bid/ask spread very wide. However, for that purpose, I found that it does not present a big issue.

 

So what it does exactly? Say that you want to buy 1,500 shares of Kraft or a value of $40,000 U.S., but you are worried about the Fed policies and that a declining USD vs the CAD$ will eat into your potential return. You could do as I mentioned and buy 4 USX puts at 106 and sell 4 calls at 106 of same duration along with your Kraft purchase. If the CAD$ goes up, the puts/calls will create an asset offsetting 1:1 your exchange rate losses on your Kraft shares. If the CAD$ goes down, the puts/calls will create a liability offsetting 1:1 your exchange rate gains on your Kraft shares.

 

This strategy eliminates the guess work about exchange rates. You buy the investment purely for what it is. The issues are that you will need a margin account to write the calls, there is a small cost when you buy and sell the put/call structure, the hedge duration is limited (but, you just have to redo the same thing at the new exchange rate upon expiry) and if your Kraft shares or other U.S. holdings change in price you may have to increase/decrease the number of options to hedge the new value.

 

Finally, it will use up some buying power (margin) when in place. It is effectively covered call writing (the liability is always matched with the asset), but since the value of your shares on margin calculation is worth less than cash, if the put/call structure turns into a liability, it will eat your margin power more than the gain in U.S.$ value of your shares. If you are levered, it could be an issue.

 

Hope this helps.

 

Cardboard

[SharperDingaan]

 

Nice touch.

 

There is a variant of this for use on concentrated holdings, where the coy's themselves have significant FX exposure that you don't want. ie: For SFK.UN you'd work out the end-of-quarter nominal USD BS exposure, & the next quarters estimated USD sales; put it into exposure/share terms, & multiply by the size of your holding to get to your share of their USD exposure for the next quarter. Then hedge it as you've described.

 

Although typically restricted to just the corporate playbook (need a big holding) it does have application at times.

 

SD

 

[valuecfa]

Cardboard,

 

This may be helpful too:

 

http://www.m-x.ca/f_publications_en/currency_options.pdf

[arbitragr]

I think for currency in particular, I would probably seriously have a look at futures. It doesn't take much to open an account.

 

For small contract sizes you can try the e-micros: http://www.cmegroup.com/trading/fx/e-micros/e-micro-canadian-dollar_contract_specifications.html

 

March contract chart: http://finance.yahoo.com/q?s=M6CH10.CME

 

 

And larger contract sizes you can go with standard contracts: http://www.cmegroup.com/trading/fx/g10/canadian-dollar_contract_specifications.html

 

If you're with IB I think they consolidate all trading in one account.

 

http://i163.photobucket.com/albums/t314/ripleyx/cad-usd.png

 

------------------

 

As an example:

 

Currently the USD/CAD = 1.060, and inverse CAD/USD = 0.9433

 

If the USD/CAD falls by 2 cents to say 1.040 then;

 

USD equity portfolio will fall in CAD terms by

 

= (100K x 1.040) - (100K x 1.060)

= -$2000 CAD

 

To hedge this we can use the USD/CAD e-micro contracts.

 

A USD equity portfolio of = $100,000 USD

 

1 e-micro USD/CAD contract = $10,000 USD

 

Contracts required to hedge = Portfolio value / contract size = 100K/10K = 10

 

Therefore you need 10 contracts to hedge. Because we believe the USD/CAD will fall in value, we would need to SHORT.

 

i.e. Hedge position value = 10 contracts x 10K = $100,000 USD

 

Value of futures contract in CAD at initial time of hedge = 100,000 x 1.060 = $106,000 CAD

 

Value of futures positoin in CAD at ending time of hedge = 100,000 x 1.040 = -$104,000 CAD

 

Profit/(loss) on hedge = -104,000 + 106,000 = $2000 CAD

 

The hedge should neutralize your USD equity portfolio position.

 

Margin requirements are small compared to options. For 1 e-micro USD/CAD contract:

 

Initial margin = $500 approx. --> 10 contracts = $5000

Maintenance margin = $350     --> 10 contracts = $3500

 

Thus you would only need at most $5000 in cash (5% of your portfolio) to hedge.

For the larger CAD/USD contract, initial margins are about 2.5K, which is 2.5% of a 100K portfolio. With the larger CAD/USD futures contract product (CDM10), because it's the reverse CAD/USD you would do the reverse of the above hedge and go long the CDM10.

 

In theory it might be a bit off, because of basis risk and the difference between spot vs. futures pricing, but not too much if you set your positions correctly.

 

 

 

[twacowfca]

You may not need to hedge your exposure to Cn $ if you are in US because

FFH's price may track the USD more than the CnD.  FFH has most of it's INS

contracts and investments balanced in USD securities.  I have had a large investment

in a LSE co with a similar USD portfolio and INS contracts, and my experience

has been that its price tracked the USD more than the £. :)