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ETFs Hedging Strategy

ETFs Hedging Strategy - How do you hedge the currency risk...

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Consider a U.S. investor who invested $10,000 in the Canadian equity market through the iShares MSCI Canada Index Fund (EWC). The ETF (Exchange Traded Funds) shares were priced at $40 at the end of June 2008, so an investor with $10,000 to invest would have acquired 250 shares (excluding brokerage fees and commissions). The ETF, the Currency Shares Canadian Dollar Trust (FXC), reflects the price in U.S. dollars of the Canadian dollar. In other words, if the Canadian dollar strengthens versus the U.S. dollar, the FXC shares rise, and if the Canadian dollar weakens, the FXC shares fall. The FXC units were priced at $100 at the end of June 2008. In six months (at the end of 2008), the EWC shares had fallen to $30. Part of this decline in the share price could be attributed to the drop in the Canadian dollar versus the U.S. dollar over this period, during which the FXC shares had fallen to about $80. EWC and FXC are the tickers for two ETFs.
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Unformatted text preview: How do you hedge the currency risk in this scenario? How much is the return of your investment portfolio at the end of 2008? Answer: To hedge exchange risk ( Here, the exchange rate risk is that Canadian dollar had a chance to weaken against US dollar at the end of 2008. You will end up with fewer US dollars as Canadian dollar depreciates at the time you want to convert investment in Canadian dollars back into US dollars by the end of 2008 ), he or she would also have sold short shares of FXC. Therefore, to hedge the $10,000 position in the EWC units, the investor would short sell 100 FXC shares ($10,000/$100 (the price of FXC at the end of June 2008)), with a view to buying them back at a cheaper price later if the FXC shares fell. The investor who had a hedge in place would have offset part of the $2,500 loss in EWC through a gain in the short FXC position, which is $2,000 (-100*(80-100)). The total return of the portfolio is -$500....
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