How Currency Overlay And Hedging Shield Investors

In the search for profits, investors are being urged to diversify their portfolios and look at investing in foreign equity markets.

However, this brings a number of risks, not least the threat that currency swings could wipe out any profit you make.

That’s because any investment in a foreign stock is also an investment in that country’s currency.

So when the currency loses value against the investor’s home currency, they suffer when converting profits back into their own currency.

Many professional investors hedge against this outcome in a process known as ‘currency overlay’.

Here’s a quick guide to understanding more:

Why do currency moves affect me?

Imagine investing in a foreign market. The investor’s currency must switch into that country’s currency to make the buy. The stock then soars in value and the investor has a profit. However, the investor’s currency hasn’t fared so well and makes a dent in that profit on switching back.

This issue has caught many Canadians out in the last 10 years. They used US dollars to buy stocks which then flourished. The rise in the US stock market wasn’t lost on currency speculators who treated the Canadian Dollar badly.

In effect, most Canadians made a profit on their US stock but ended up with less money than they started out with because the Canadian Dollar had performed so poorly.

So what can currency overlay do about exchange rate fluctuations?

To hedge, an investor should double up their investment by buying the same amount of foreign currency as their initial stock investment is worth and ‘hedge’ against the rise and fall of the stock’s investment. This is ‘currency overlay’.

Why do it?

You are looking at a win-win situation. In the above example, if the Canadian Dollar rose in value, any loss would have been covered by the currency hedge – making a profit.

Likewise, a US Dollar rise would see the stock profits increase and with the poor performance of the Canadian Dollar his return would have been much greater.

How can I do it?

With the spread of forex trading, especially online, it’s a straight forward task to buy currency and hold against a foreign investment.

What’s the risk?

While many investors utilise currency overlay and then sit back, some investors hedging against their investments are tempted to trade on forex markets and increase their profits still further. This is known as passive and active hedging.

Without real knowledge of how forex works, it’s probably best that investors aren’t tempted to risk their investments.

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