Foreign exchange explained

What is foreign exchange?

Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country. When you wish to purchase foreign securities, such as U.S. stocks, you need to do a currency exchange (i.e. convert Canadian dollars to U.S. dollars) before you can make the purchase.

The exchange rate is the rate at which one currency will be exchanged for another, and this rate depends on the value of a country’s currency in relation to another country, which means that the exchange rate can fluctuate over time.

What is currency risk (aka exchange rate risk)?

When you invest in foreign securities, you take on currency risk in addition to price risk. If you buy a security, price risk is the risk that the price of the security will fall and lead to a loss. Currency risk is the risk that the exchange rate will fluctuate and lead to a loss. When the exchange rate fluctuates, that means that the value of one currency changes relative to another currency, and this can happen to your disadvantage.

For example, if the Canadian dollar weakens, the value of your foreign portfolio rises. On the other hand, if the Canadian dollar strengthens, the value of your foreign portfolio falls.

To recap, when you invest in a foreign security, you can make gains or losses based on the price movement of the security. In addition to that, movements in the exchange rate can further add to these gains or losses.

Examples of the impact of currency fluctuation

Assume the USD to CAD exchange rate is 1.30 and you want to buy US$10,000. You’ll pay CAD $13,000 (1.30 × US$10,000).

Example 1

If you hold onto the U.S. dollars and the exchange rate moves to 1.35, which means the Canadian dollar weakens, the value of your U.S. dollars increases to CA$13,500 (1.35 × US$10,000). You’ve made CA$500 ($13,500 − $13,000) from holding the U.S. dollars.

Conversely, if the Canadian dollar strengthens and the exchange moves to 1.25, the value of your US dollars decreases to CAD $12,500 (1.25 × US$10,000). You’ve lost CAD $500 ($12,500 − $13,000).

Example 2

Assume once again that the USD to CAD exchange rate is 1.30, but this time you want to buy 100 shares of ABC Corp at US$100 per share. You’ll pay CA13,000 excluding commissions (100 shares × US$100 per share × 1.30).

At the time of purchase, your total portfolio value will be CA$13,000. This value will change based on the share price of ABC Corp and the USD to CAD exchange rate.

If ABC Corp rises to US$105 per share, and the Canadian dollar weakens to an exchange rate of 1.35, you benefit from both the rise in stock price and the currency fluctuation. Your shares are now worth US$10,500 ($10,000 + $500), or CA$14,175 ($10,500 × 1.35). That’s a gain of CAD $1,175 ($14,175 − $13,000).

On the other hand, if the stock price drops to US$95, your loss can be offset by the gain from a weakening Canadian dollar. Your shares would drop by $500 to US$9,500, or CA$12,825. That’s a loss of CA$175 ($13,000 − $12,825), despite the US$500 drop in stock price. In this scenario, currency fluctuation helps to reduce the loss.

Ways to minimize currency risk

Currency fluctuation can have a positive or negative impact on the overall portfolio, and there are investors who want to avoid it. Typically, they would consider some of the following ways to minimize currency risk:

Currency-hedged ETFs or mutual funds that reduce or eliminate the effects of foreign exchange movements.
Globally diversified portfolio with a basket of countries or regions that offer exposure to a variety of currencies.
Basket of currencies with minimal correlation because correlated currencies tend to move together.

Learn how to place foreign exchange cash conversion orders online