Knowledge & Education Center

Managing Exchange Rate Risk

Where do you see the exchange rate going? This is a common question amongst our client base, many of whom enjoy a cross border lifestyle.  In fact, as Americans living in Canada may have noticed, the exchange rate is right up there with hockey and the weather in Canada’s national conversation.

The trouble is, accurately predicting the exchange rate is exceedingly difficult over both short- and long-term periods.  Even amongst currency analysts, who are the experts in this field, there is usually no consensus, a lone exception possibly existing when the loonie is trading at extreme values (either above par, or at 60 cents on the dollar).

The loonie is not currently at either extreme, but it has been volatile.  It fell about 8% against the greenback in 2018, rose significantly in January 2019 and moved lower through March.  Why is it so volatile, and why is it inherently difficult to predict the direction of the exchange rate?  The rate is impacted by more than one factor, which may push it in opposite directions.  For instance, the loonie is sometimes described as a petro-currency, driven by the price of oil.  As the price of oil (which is priced in USD) increases, all else being equal, the Canadian dollar would also increase relative to the US dollar.

The loonie is also driven by the differential between US and Canadian interest rates.  If rates on Canadian bonds are higher than those available in the US, then investors from outside Canada will tend to invest more money in Canada.  To purchase these investments, they need to convert their money into Canadian currency, driving the demand for loonies upward. This raises the value of the loonie relative to the US greenback.

It’s certainly possible to have the price of oil and the interest rate differential between Canada and the US pushing the exchange rate in opposite directions.  In the situation where oil prices are declining yet Canadian interest rates are rising relative to the US, it’s an open question which factor will have more impact.

Aside from these types of macroeconomic currency catalysts, there’s a school of thought that looks at what the value of a currency “should” be, based on equalizing what money can buy in various countries.  This is known as Purchasing Power Parity.  On this basis, the Canadian dollar is undervalued and should be worth somewhat more than it is now.  Unfortunately, it can stay this way for years, and does not spend much time at parity.  As a result, this metric is interesting but not necessarily any more helpful than other foreign exchange predictions for long term planning.

Given the notion that experts and scholars cannot make accurate predictions, how can cross-border financial planning be undertaken, and investment portfolios designed, for clients with assets in both currencies domiciled on either side of the border?  Financial planning is, to some extent, the practice of making assumptions about the future in order to provide clients with a picture of how that future will unfold provided the assumptions are perfectly correct.  As a result, financial plans are best presented with the caveat that they need to be refined over time to accommodate revisions to the assumptions as conditions change.

Unfortunately, the foreign exchange rate over the client’s lifetime is not the only unknown variable to consider.  Future rates of inflation and taxes on both sides of the border, as well as returns on investments in the stock and bond markets, are critical inputs.  Since the actual future values for these variables are uncertain, risk management tactics are utilized in portfolio design to reduce these risks.  This is equally true when it comes to currency risk.

One important consideration in cross-border wealth management is hedging investment securities into the currency of the country where retirement income will ultimately be spent.  It is often argued, correctly, that currency fluctuations tend to even out over the long term, and there is a financial cost to hedging strategies.  However, over the short term, those fluctuations can have a significant impact on investment portfolios and the income they provide.  While this extra layer of volatility can be worrisome for clients at any stage of life, it becomes increasingly critical when it has a direct impact on the amount of retirement spending a client can do from one year to the next.  A cross-border wealth management firm like Cardinal Point will use a prudent hedging strategy to manage the costs and benefits appropriately.

In addition, where possible, migrating assets over time into the client’s expected currency of residence in retirement can make a lot of sense.  For example, Americans working in Canada who plan to move back to America in retirement may hold their RRSPs in US dollars. The result is the minimization of the currency impact they experience long term.  Reducing the variability of future returns based on  exchange rate risk brings a dimension of certainty into an uncertain future.

Finally, it’s important to pay attention to the costs of converting money from one currency to another.  These costs can be 2% or more of the amount of money being converted.  If there is an ongoing need for a certain currency, a bank account denominated in the currency can be used to meet this need.  It’s best to minimize the movement from one currency to another, which can occur when money is moved between bank accounts, or a credit card issued in one country is used outside that country.  Where the need for conversion exists, using a specialized service provider such as OFX can result in significant savings on the transaction.

The exchange rate between the US and Canadian dollar is a significant source of risk for many clients. For Americans living in Canada and Canadians living in America, working with a cross-border financial planning firm is a prudent way to manage this significant financial and emotional process.

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