Tuesday, June 28, 2011

Currency Conversion Costs

For years I freely bought and sold U.S. stocks without giving too much thought to the cost of converting between U.S. and Canadian dollars. I tended to worry much more about the visible trading commissions. After combing through some old trading information I’ve found that my currency conversion costs were much higher than the commissions I paid.

I looked over all my trades since I began investing on my own about 13 or so years ago. I identified all the trades of U.S. stocks where I settled the trade in Canadian dollars. My discount broker, BMO Investorline, conveniently handled the currency conversion as part of the trade. I eliminated cases where the trade value was less than US$2500 and where I used wash trading. (Wash trading is a way to eliminate currency exchange costs on round-trip currency conversions). This left 49 trades.

For each trade I looked up the fair U.S./Canadian dollar exchange rate on the day in question to calculate how much extra I paid above this fair exchange rate. Of course there were differences between the noon exchange rate quoted in historical data and the actual exchange rate at the time of day I did each trade. However, averaged out over 49 trades, these small differences tend to balance out.

This process gave me the following totals (in Canadian dollars):

$7374 – total extra currency exchange costs
$1813 – total commissions paid (I made many trades before commissions dropped to the now typical $10 or less)

For all the attention I focused on commissions, I was paying about 4 times more for the partially hidden currency exchange costs. This looks even worse with today’s trading commissions: If I had paid US$10 per trade, the total commissions would only have been about $600, which is only about one-twelfth of the actual currency exchange costs I paid.

If the currency exchange method described by Canadian Capitalist had existed (with $10 commissions) when I made these trades I could have reduced my currency exchange costs to $3011 (saving $4363 compared to what Investorline charged me).

The bottom line is that currency conversions are more expensive than they seem. Investors should pay attention to these costs.

11 comments:

  1. I must be missing something... why are you trading US stocks in a CAD account?

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  2. wow... my hands were shaking when I read how much the banks had charged you. And I thought I had it bad when they took $600 from me.

    *sigh* knowledge is power, and they will always take advantage of those without knowledge.

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  3. @Matt: Keep in mind that this is 49 trades over about 12 years. That's only one trade that included a currency conversion every 3 months, on average. All other trades I during those 12 years did not involve currency conversions.

    The bulk of the situations fell into the following categories:

    - I was buying or selling a US stock in an RRSP and didn't have another trade to pair it with for wash trading.

    - I was buying a US stock but was out of US cash.

    - I was selling a US stock and planned to use the proceeds (in Canadian dollars) for non-investing purposes.

    @Anonymous: You're right that knowledge is power. I wish I hadn't learnt this one the hard way, but there's no use crying now.

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  4. Interesting analysis Michael.

    I was totally ignorant about currency exchange costs when I started using ETFs. Luckily I did all my conversions at Questrade which has much cheaper forex costs in registered accounts (0.5%) than most other brokers, but those conversion costs were still much higher than the trading commissions.

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  5. Michael, you have to be careful what exchange rate you are using as a comparison. As a client of BMO InvestorLine also, I questioned their exchange rate when I was buying US stocks and was told the quotes you see in the media are for large sums, possibly in the millions.

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  6. Michael, I just went in to the website and did two quotes for buying US dollars. At $10k, the quote was 0.998, at $50k, the quote was 0.9925. I'm curious as to how you determine a fair U.S./Canadian dollar exchange rate as it does relate to the size of the transaction.

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  7. I used to settle in different currencies willy nilly. At that time, I was just getting into individual stocks, and ignorant of currency conversion costs. Now I realize, as you mention, that conversion fees are probably more profitable for the brokerages than trading commissions.

    While trading commissions are always prominently posted, currency fees are sometimes harder to assertain.

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  8. @Mike: I was mostly ignorant of currency exchange costs years ago, but I have no excuses now.

    @Ahmed: By "fair" I don't mean that the brokerage gets a fair profit. I mean an exchange rate that is roughly in the middle of any bid-ask spread. This is what the Bank of Canada and other web sites quote for historical exchange rates. So, I could not reasonably have expected to save the entire $7374 (you can't expect businesses to do work for free). However, if I had paid more attention I could have saved most of it.

    @Gene: Currency exchange costs are definitely less prominent than stock-trading commissions.

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  9. @Ahmed: Did you also check the selling rate for US dollars? The mid-point of the two is more or less what you'll see published in official exchange rate tables. The difference between the buy rate and the mid point is a reasonable approximation of what currency conversions is costing investors.

    I agree with Michael here. If you buy $5,000 worth of US securities, it will cost you $10 in commissions and $75 in foreign exchange fees.

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  10. Wow, this was an eye-opener for me.

    I guess I can conclude a few things from this:

    1) Be mindful of the currency conversion when you make a U.S. transaction.
    2) Don't trade often, if at all.

    Do you think over a long holding period, say 20+ years, the U.S. currency risk isn't a big deal? Or is it Michael?

    I've always been skeptical or a downright pessimist when it comes to foreign exchange fees charged by brokerages. The word gouging comes to mind.

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  11. @Mark: Currency risk is real, but there is a difference between holding U.S. dollars and holding U.S. stocks. I'm comfortable holding a basket of international stocks without any form of currency hedging, but each investor has to make his or her choice.

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