A recent query (from M. Heng) about a recommendation I made on BNN on November 20th. I recommended buying CurrencyShares Canadian Dollar Trust (symbol FXC) as a play on the US dollar. FXC is effectively an exchange-traded fund that rises or falls in line with the performance of the Canadian dollar vis-à-vis the US dollar.

We were short for time on that particular segment, which quite frankly, is an issue anytime you are dealing with thirty second sound bites. On the Nov. 20th show, I suggested that FXC would rise if the US dollar continued to decline. Which is correct. But, since FXC is traded in US dollars, any increase or decrease in value has no benefit for a Canadian investor. That should have been said, and had time permitted, would have been.

What I also wanted to say – had time permitted – was the fact that FXC was a tool to hedge against the currency risk associated with US holdings. For example, say you owned US $10,000 worth of SPY (S&P 500 Depositary Receipts). SPY, of course, trades in US dollars. If SPY rallied 10%, your investment would be worth US $11,000. But what happens if over the same period, the Canadian dollar also rallied by 10%. When you convert your US dollar investments back into Canadian dollars, you gain nothing. And there lies the value of hedging.

In the SPY example, you could hedge against the risk of currency fluctuations by buying US $10,000 worth of FXC. A 10% rally in the Canadian dollar would push up the value of FXC by 10%. When you combine the returns of FXC and SPY you end up with a 10% net return over the holding period.

Of course the cost of purchasing the FXC exchange-traded fund outright, overshadows the benefits of the hedge. A better approach would be to buy FXC calls and sell FXC puts at the same strike price. The premium received from the put should offset the cost of the call which means no out of pocket cash is committed to the hedge.

Because a long FXC call / short FXC put combination is equivalent to a long futures contract on the Canadian dollar, that’s typically the approach institutional investors take when trying to hedge currency risk.

Coming full circle we arrive at USX which is a currency option that trades on the Montreal Exchange. USX allows you to profit on your outlook for the US dollar vis a vis the Canadian dollar. In this case, the options are traded in Canadian dollars and the underlying currency is US dollars. The exact opposite of FXC and the only way for Canadian investors to profit from a shift in exchange rates.
Sticking with USX which trades in Canadian dollars, you would buy USX calls if you thought the US dollar was set to rise against the Canadian dollar. If you believe the Canadian dollar will rise against the US dollar, USX would decline and a long USX put position would profit.