When you buy an asset denominated in a foreign currency, your return is determined by two factors: the return of the foreign asset and the return of the currency. The impact of exchange rate movements on your return can be reduced by hedging currency exposure of that foreign asset.

A wise man once told me that it is not the questions you have failed to answer that you should fear: rather, it’s the questions you have failed to ask!

Let’s say you’ve had a couple of great years in your business or have recently liquidated your business. The proceeds represent years, even decades, of the blood, sweat and tears you have put into the growth and control of your business. Now you have to make a decision that will significantly affect your lifestyle and financial security: What to do with the proceeds? You know that you want to retire and that part of your cash flow will come from non-active business assets. Creating an investment portfolio clearly makes sense as it frees up time and energy for your family and retirement travel. However, this strategy presents new challenges: it removes you from the direct control of your assets that you are accustomed to as a business owner, and it opens you up to global financial markets and a whole new set of risk and return factors. There are many decisions to be made . . . and you have to find the right questions to ask in building an investment portfolio that will serve your needs.

Whether you make your own investment decisions or rely largely on a trusted financial advisor to manage your portfolio, it’s prudent to make the effort to understand the issues involved in building a personal portfolio of liquid financial assets. Today’s article deals with one of the more complex aspects: the advisability of hedging currency on foreign investments.

In prior articles we have reviewed the importance of having a significant position of your public stock portfolio invested in foreign markets, because diversifying your investments can increase expected returns and reduce overall volatility.

When you buy an asset denominated in a foreign currency, your return is determined by two factors: the return of the foreign asset and the return of the currency. The impact of exchange rate movements on your return can be reduced by hedging currency exposure of that foreign asset.
You must decide whether you want to incur the impact of exchange rate movements of the country in which the investment resides against the currency with which you are making the purchase. A straightforward approach would be to hedge all foreign investments in order to remove all volatility related to currency. However, two primary additional considerations complicate this decision: 1) Will the volatility of the foreign currency adversely affect the portfolio? and, 2) What is the cost incurred by the portfolio to arrange and manage the hedged position?

It is important to establish a framework for making these decisions. After decades of research, there is no solid evidence that currency movements can be anticipated with any degree of certainty. However, some global currencies do correlate to one another, so it is possible, for example, to measure how closely the movements of the Canadian dollar match the U.S. dollar or the Japanese yen. And we know that not all currencies are correlated: that is, they do not all move in the same direction at the same time. This lack of correlation, or negative correlation, can either represent risk, having a negative impact on the overall portfolio; or it can represent opportunity, if it has the potential to reduce overall portfolio volatility.

The cost to establish a hedge on your portfolio to offset exchange-rate movements in foreign currencies must be measured against the offsetting reduction in risk or lost returns due to currency movements.

The risk to your overall portfolio depends on the proportion of foreign investments and the number of currencies involved. If only 20% of your portfolio is exposed to foreign exchange rate movements, risk related to that position is less of a concern than if you have 80%. The number of international currencies you are exposed to also has an impact, as the risk of currency movements is reduced by having exposure to multiple foreign currencies: i.e., if your exposure is to a single currency, you are more at risk than if you have 20 different currencies.

Review your portfolio in light of the issues raised above. Do you have exposure to foreign exchange rate movements? If this is by design, how is it being handled to your advantage? How much of your portfolio is exposed to foreign currencies? Do you spend money in the U.S. and, if so, should you have money specifically allocated to the U.S. market to represent your spending while you're there? These are some starter questions for you to consider and discuss with your portfolio manager. Once again, asking the right questions sends you in the right direction!

This article by Daryn Form was published in the June 2012 edition of Sask Business Magazine.

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.  The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  The opinions expressed are those of the author and not necessarily those of Assante Capital Management Ltd.  Rates are not guaranteed and are subject to change at any time without notice.