Wednesday, March 19, 2014

Reader Question: How to Protect Yourself against the Dropping Canadian Dollar

A thoughtful reader asked me about how Canadians can protect themselves against our dropping Canadian Dollar. I won’t name this reader because I intend to answer this question more forcefully and bluntly than usual. This may come across as wrath against this particular reader but that isn’t my intention. I want to shake up people’s thinking.

Here is the beginning of the (lightly edited) question:
Predictions abound that the Canadian dollar will drop in value relative to the U.S. dollar. This might be due to the overall economic forces, or maybe the election of PQ and the Neverendum issue.
First of all, “Neverendum” is clever; kudos to whoever thought of it first. Next I have a message for the people of Qu├ębec: Don’t listen to the vocal minority in the rest of Canada. We love you. Please don’t go.

Predictions about the Canadian dollar are worthless. Do you seriously believe that Canada’s current economic and political issues have somehow escaped the attention of the people who collectively risk not millions, not billions, but trillions of dollars in currency markets?

Confident speakers can sound persuasive on either side of the question of which way the dollar will go. They’re going to be right half the time, but that doesn’t mean they have any useful insight. Suppose I say “heads and the dollar goes up, tails it goes down.” Then I toss heads and the dollar happens to go up. Does this mean I was right? Does it mean the coin was right? No and no. My prediction was worthless along with all the other smarter-sounding predictions.

The sooner we all admit that we don’t know what will happen to the dollar, the sooner we can stop putting ourselves at risk of making foolish bets.
Presumably sophisticated investors can protect against the dropping dollar. Maybe people planning a vacation in the U.S. and would like to protect themselves against a big drop in Canadian dollar.
Sophisticated investors can make a bet that the Canadian dollar will drop. Unsophisticated investors can make similar bets. However, once you admit you don’t know what will happen to the dollar, you start to think about reducing uncertainty. This means that you reduce the risk of loss if the dollar drops, and you also give up the possibility of a gain if the dollar rises.

Protecting against the downside while keeping all of the upside cannot be done. You can use certain types of derivatives to reduce downside volatility, but they have a cost. Anything that looks like insurance always has a premium to pay. It’s better for the typical person to think about lowering uncertainty rather than just eliminating the down side.
Perhaps we could put cash in a U.S. dollar savings account at a local bank (and pay retail exchange rates). Or should people with a brokerage account buy a cross-listed stock and hold it in U.S. dollars instead of Canadian dollars?
Now we’re on the right track. If you want protection against the uncertainty of holding Canadian dollars but having expenses in U.S. dollars, the solution involves holding assets that depend on the U.S. dollar.

There are two separate issues here. One is how to keep exchange rates down when exchanging Canadian dollars for U.S. dollars. The other question is what assets you should hold.

Currency Exchange

The key to currency exchange is to plan ahead so you don’t do it too often. It’s expensive enough to exchange some money once without bouncing the same lump of cash back and forth several times. The costs are hidden in the exchange rate. There is a gap between the rate you get going from Canadian to U.S. and the rate you get going from U.S. to Canadian. This gap means that a “round-trip” from Canadian to U.S. and back again leaves you with less money than you started with.

No matter what method you use to do currency exchange, there will be an exchange-rate gap that costs you money. For small transactions, it’s hard to do much better than the rates you get at the big banks. However, for those with self-directed trading accounts, consider learning about the Norbert Gambit.

What U.S. Assets Should You Hold?

For near-term expenses, cash makes a lot of sense. U.S. dollar savings accounts or the U.S. side of discount brokerage accounts make sense. For snowbirds with longer-term expenses, consider assets like U.S. stocks and bonds.

However, be sure that the assets you choose are actually depend primarily on the U.S. dollar. The specific example of using a cross-listed stock does not work. Take the example of Royal Bank stock. Whether you own RY on the TSX in Canadian dollars or RY in the U.S., you own exactly the same asset. You will be exposed to the same currency-related risks no matter which version of RY you buy. The particular currency you use to buy a stock isn’t necessarily the same as the currency that most influences the underlying business.

If you wish to own stocks and bonds that depend primarily on the U.S. dollar and denominated in U.S. dollars, one place to look is Vanguard exchange-traded funds which can be purchased from a Canadian brokerage account. There are a few things to watch out for if you decide to try this route:

Hidden currency exchanges: If your Canadian brokerage account only holds Canadian dollars, you may be paying currency exchange costs every time you buy or sell an ETF denominated in U.S. dollars.

Proper Financial Plan: Make sure that whatever you own in U.S. dollars works with the rest of your assets to form a sensible and consistent financial plan.

U.S. Estate Taxes: People whose entire estate (not just the U.S. part) is large enough can be subject to U.S. estate taxes on death.

As with many things in life, making sensible choices about protecting yourself against the dropping Canadian dollar starts with understanding. The right course of action follows from that understanding.

12 comments:

  1. An anonymous reader left the following comment that seems to have become lost:

    "Purchasing power parity (PPP) is a gross indicator of value changes in currencies. The Economist magazine publishes the Big Mac index which gives a practical view of the value differences. During the commodities boom in the last five years it was possible to purchase US assets at a discount. Now that the Canadian petrodollar is weakening, the value of US assets are appreciating back to more normal values but there's still room to grow. A subtle shift of emphasis in currency weights has generated a six figure value for our portfolio. We expect to shift the portfolio emphasis back to C$ assets on the coming years. Having long views and patience may not be natural to everyone, but for some of us, it's just a practical application of seeing valuation differences and taking advantage of the values available.

    Your milage may vary from ours..."

    I'm not impressed by those who predict the past. Can you be more specific about your plans to shift back to Canadian dollars? Do you have a theory about who is trading currencies so badly that you can profit by taking advantage of them? I find it hard to believe that other currency traders are idiots and you can profit from them easily.

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  2. I don't have any need for USD so I haven't really thought much about this. Some of my Canadian stocks, though, happen to pay their dividends in USD. (e.g. BIP and BEP.UNs) so I keep them in my USD ledger.

    Would stocks like these be of any use to people needing a USD income?

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    1. @Bet Crooks: It's one thing to receive income in U.S. dollars, and quite another to minimize exposure to movements of the U.S. dollar against other currencies. These stocks seem to have world-wide exposure, so they are not ideal for reducing currency risk for those who spend U.S. dollars. However, a bigger issue is whether they fit into a sound portfolio. Taking on the risk of owning individual stocks is a dangerous business. Most people who do this are taking on uncompensated risk.

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    2. Cool! I never thought of myself as a risk taker. It's nice to feel like I'm living dangerously for a change. ; )

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    3. @Bet Crooks: The only trouble is that certain kinds of risks increase your expected payoff and other don't.

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  3. I'm paying tuition in USD, so in November had a big chunk of change converted into USD as I figured it wouldn't get much better than close to parity and was correct.

    As for the 'please don't go Quebec' mentioned... I think I tend to represent a good chunk of Canadians who in the 1990s would have said 'please don't go Quebec' but are now kind of like the beaten down housewife who says 'stay or go, but if you stay you stay, and if you go, you go' (meaning no more referendum talk if you stay, or all funding stops if you go, and all federal government assets are immediately withdrawn from your border except for the Canadian embassy in Quebec).

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    1. @Geoff: I'm confident that I could make such calls correctly about half of the time :-)

      I share your frustration with the never-ending nature of whether Quebec will stay or go. However, when I think through the consequences to us all if Canada breaks up, I realize that I want to stay together.

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    2. I honestly think the pro-separation Quebeckers don't fully understand the consequences of separation from Canada. We're not going to play nice if that happens. It really needs to be spelled out clearly if there is another neverendum.

      Borders to maintain, everything considered federal like land, water, etc remains with Canada (which we can sell or lease to Quebec at what I'm *SURE* will be reasonable rates ;-) ), have to field own military (and those Quebeckers in the military are out), all federal Quebec employees are out, $146B of our national debt is handed over to Quebec, get your own currency, get your own trade agreements, get your own ambassadors and facilities, the Natives aren't stupid and will likely want to remain "in Canada", whatever federal support payments stop, a lot of companies may uproot not to mention people, ...

      Quebec has a pretty sweet deal here already.

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    3. Actually the debt figure is $163B. I didn't realize that the website http://www.nationaldebtclocks.org/debtclock/canada had the figures by default in US$. Javascript is turned off by default in my Firefox.

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    4. @lister: I think you're right that those who a pro-separation don't fully understand the consequences. But I think those in the rest of Canada who say "let 'em go" don't understand the consequences. I think both sides would lose.

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    5. The major force behind the separation of Quebec from Canada is the politicians (read PQ mainly). Why? Because it is the only cat they have to flog to remain in power. After all, don't politicains like power. Power corrupts and absolute power corrupts absolutly - heard that some place before. So they play the "master of our own house" rant to the less brilliant. As to what would happen to the ROC (rest of Canada) if Quebec were to cleave itself out. In my opinion the Maritimes would be part of the US of A within five years. I am sure the Yanks could learn to love the Newfies especially with Hibernia. And I bet they would re-negotiate the Churchill Falls hydro agreement pretty fast whether Quebec liked it or not. As to Central/Western Canada within ten years it is part of the US of A. All my opinion and conjecture. I wonder what Pauline would say to the Yanks when they say they are putting Spanish on the cereal boxes instead of French LOL
      So if you like/Love Canada, in my humble opinion pray that the PQ never pull the plug

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    6. If there is yet another referendum, the Feds need to spell out exactly in plain English and French what Quebec separation means and what is going to happen to Quebec. I'd be really curious what the vote would be if the people knew that the warm and fuzzy utopian line of BS the PQ spouts simply won't happen.

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