A more detailed example of a trade deficit would be if a country imports much more than it exports. You end up with too many importers dumping their countries' currencies to buy other countries' currencies to pay for all the goods they want to bring in. Then the value of the importers' country currencies drops because the supply exceeds demand.

To illustrate the impact of currency exchange rates on investment returns, let's go back to the first decade of the new millennium — which proved to be a very challenging one for investors. Equity markets in Canada, the largest trading partner of the U. Hedging exchange risk was not advantageous in these circumstances since these U. However, a weakening currency can drag down positive returns or exacerbate negative returns in an investment portfolio. In this case, an investor who wanted to be invested in Canadian equities while minimizing exchange risk could have done so using currency ETFs.

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With currency ETFs, you can invest in foreign currencies just like you do in stocks or bonds. These instruments replicate the movements of the currency in the exchange market by either holding currency cash deposits in the currency being tracked or using futures contracts on the underlying currency. Either way, these methods should give a highly correlated return to the actual movements of the currency over time. These funds typically have low management fees as there is little management involved in the funds, but it is always good to keep an eye on the fees before purchasing.

Exchange Rate Risk

There are several choices of currency ETFs in the marketplace. You can purchase ETFs that track individual currencies. You can also purchase ETFs that track a basket of different currencies. For example, the Invesco DB U. In general, much like other ETFs, when you sell an ETF, if the foreign currency has appreciated against the dollar, you will earn a profit. On the other hand, if the ETF's currency or underlying index has gone down relative to the dollar, you'll end up with a loss.

Consider a U. This ETF reflects the price in U. In other words, if the Canadian dollar strengthens versus the U. Recall that if this investor had the view that the Canadian dollar would appreciate, he or she would either refrain from hedging the exchange risk or "double-up" on the Canadian dollar exposure by buying or " going long " FXC shares.

However, since our scenario assumed that the investor wished to hedge exchange risk, the appropriate course of action would have been to " short sell " the FXC units. In this example, with the Canadian dollar trading close to parity with the U. Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U. The investor who had a hedge in place would have offset part of this loss through a gain in the short FXC position.

How Companies Use Derivatives to Hedge Risk

Some investors may believe that it is not worthwhile to invest a dollar in a currency ETF to hedge each dollar of overseas investment. However, since currency ETFs are margin -eligible, this hurdle can be overcome by using margin accounts brokerage accounts in which the brokerage lends the client part of the funds for investment for both the overseas investment and currency ETF. Note that making investments on margin amounts to using leverage , and investors should ensure that they are familiar with the risks involved in using leveraged investment strategies.

Currency moves are unpredictable, and currency gyrations can have an adverse effect on portfolio returns. As an example, the U. These currency moves amplified negative returns on overseas assets for U. Hedging exchange risk is a strategy that should be considered during periods of unusual currency volatility. Because of their investor-friendly features, currency ETFs are ideal hedging instruments for retail investors to manage exchange risk. Library of Congress Business Reference Services. Energy Information Administration. Accessed June 9, Global News Canada. Financial Industry Regulatory Authority.

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To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page. These choices will be signaled globally to our partners and will not affect browsing data. A currency swap is a financial instrument that involves the exchange of interest in one currency for the same in another currency.

Currency swaps comprise two notional principals that are exchanged at the beginning and end of the agreement. These notional principals are predetermined dollar amounts, or principal, on which the exchanged interest payments are based. However, this principal is never actually repaid: It's strictly "notional" which means theoretical. It's only used as a basis on which to calculate the interest rate payments, which do change hands. Here are some sample scenarios for currency swaps.

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In real life, transaction costs would apply; they have been omitted in these examples for simplification. Assuming a 0. Now, let's take a look at the physical payments made using this swap agreement. At the outset of the contract, the German company gives the U. Subsequently, every six months for the next three years the length of the contract , the two parties will swap payments.

The German firm pays the U. The U. The two parties would exchange these fixed two amounts every six months.

Three years after initiation of the contract, the two parties would exchange the notional principals. Accordingly, the U. Using the example above, the U. These types of modifications to currency swap agreements are usually based on the demands of the individual parties in addition to the types of funding requirements and optimal loan possibilities available to the companies.

Either party A or B can be the fixed rate pay while the counterparty pays the floating rate. In this case, both the U. The rest of the terms of the agreement remain the same. Recall our first plain vanilla currency swap example using the U. There are several advantages to the swap arrangement for the U. First, the U. The more competitive domestic interest rate on the loan, and consequently the lower interest expense, is most likely the result of the U. It is worthwhile to realize that this swap structure essentially looks like the German company purchasing a euro-denominated bond from the U.

Other instruments, such are forward contracts, can be used simultaneously to hedge exchange rate risk. Investors benefit from hedging foreign exchange rate risk as well. Using currency swaps as hedges is also applicable to investments in mutual funds and ETFs. You need to hedge your currency risk to benefit from owning your fund over the long term.

Many investors can reduce their risk exposure by using currency-hedged ETFs and mutual funds. A portfolio manager who must purchase foreign securities with a heavy dividend component for an equity fund could hedge against exchange rate volatility by entering into a currency swap in the same way as the U. The only downside is that favorable currency movements will not have as beneficial an impact on the portfolio: The hedging strategy's protection against volatility cuts both ways.

Companies that have exposure to foreign markets can often hedge their risk with currency swap forward contracts. Many funds and ETFs also hedge currency risk using forward contracts. A currency forward contract, or currency forward , allows the purchaser to lock in the price they pay for a currency. In other words, the exchange rate is set in place for a specific period of time. These contracts can be purchased for every major currency. The contract protects the value of the portfolio if exchange rates make the currency less valuable—protecting a U.

So, there is a cost to buying forward contracts. Funds that use currency hedging believe that the cost of hedging will pay off over time. The fund's objective is to reduce currency risk and accept the additional cost of buying a forward contract. Consider two mutual funds that are made up entirely of Brazilian-based companies. One fund does not hedge currency risk. The other fund contains the exact same portfolio of stocks, but purchases forward contracts on the Brazilian currency, the real.

If the value of the real stays the same or increases compared to the dollar, the portfolio that is not hedged will outperform, since that portfolio is not paying for the forward contracts. However, if the Brazilian currency declines in value, the hedged portfolio performs better, since that fund has hedged against currency risk. Currency risk doesn't only affect companies and international investors. Changes in currency rates around the globe result in ripple effects that impact market participants throughout the world.

Parties with significant forex exposure, and hence currency risk, can improve their risk-and-return profile through currency swaps. Investors and companies can choose to forgo some return by hedging currency risk that has the potential to negatively impact an investment. Trading Instruments.