Hedgers generally account for 20 percent, and in certain markets up to 40 percent, of the volume in the major futures markets. Hedgers use contracts on the futures exchanges to offset the risk of fluctuating prices when they buy or sell an asset. 

For example, a copper mining company may sell copper futures today to lock in a sale price for its future production. In this way, the company protects its profit margins and revenue stream should copper prices drop in the future. Should copper prices rise, the company will lose on its hedge position; however, the value of its physical metal will rise. The copper miner is just trying to offset–or hedge–its price risk. 

A hedger can be a buyer or a seller, and could just as easily be involved in a financial asset–such as the Canadian dollar–as a commodity. Hedgers in both commodities and financial investments use the futures as a pricing tool to help stabilize revenues and protect profits.

I was asked to write this piece to help Canadian Edge subscribers and investors learn how to use the Canadian dollar futures to hedge their Canadian dollar-denominated investments.

The objectives of hedgers and speculators are not the same. The speculator is always looking to make money on his transactions. The hedger isn’t always looking to necessarily profit on the futures side of his transactions.  

For the Canadian trusts, the value of your monthly distributions is based on the Canadian dollar (CAD), and your shares are generally priced in Canadian dollars.

Let’s say you’re anticipating a return over the next six months, but it will depend to an extent on the value of the Canadian dollar. The CAD is trading at 95.7 cents to the US dollar (USD) as of this writing. You’re currently in a good profit situation, but your profits could be wiped out by exchange rate fluctuations. There could also be a windfall gain if the CAD moves up in relation to the USD within the same time period. The six-month CAD is currently trading at approximately 96 cents to the USD. Let’s say you have $100,000 in Canadian investments. You could sell the six-month CAD futures and assure yourself the 96 cent exchange rate.

Let me explain.

Hedges come in two basic forms, the short and the long. Canadian trust investors who believe the Canadian dollar is due for a tumble will want to look at a short hedge. (Later in this article we’ll discuss how to benefit from Canadian dollar appreciation.)

A short hedge is entered into to protect the value of an asset. Let’s look at an example. A portfolio of Canadian trusts worth $100,000 constantly changes in value not only due to share prices but also due to currency fluctuations. A short hedge is used by the owner of an asset to essentially lock in the value of the asset. A decline in prices generates profits in the futures market on the short hedge. These profits will be offset by depreciation in the asset value.  Energy prices might go up and push the share price of an energy-related Canadian trust up in Toronto, but it could still decline in value in the US if the Canadian dollar declines. 

In August an investor anticipates the Canadian dollar could fall to 92 by December. But the monthly income stream from the Canadian trusts is good; why sell them and incur additional commissions by buying and selling the shares (which can be illiquid at times)? 

Here’s what the investor might do in the futures market: Sell one December Canadian dollar futures contract (each contract is for $100,000, but due to futures leverage the deposit required is currently only about $1,500) at 96 cents, which locks in a currency value at this level. 

Let’s suppose he was correct about the price falling, along comes October 15 and the price of the Canadian dollar has fallen to 93 cents. Because the futures mirror the cash fairly closely, the futures will also fall in price. Let’s say the futures on that date were quoted at 93. He could buy back his contract at this price, reaping a futures profit of $3,000. 

This is calculated as follows: a $100,000 contract multiplied 300 basis points equals $3,000. Every penny move in one Canadian dollar contract is equal to a profit or loss of $1,000 per contract. The futures gain of $3,000 in this case offsets an inevitable loss in value of the portfolio, and he has in effect protected the value of his portfolio at the August price.

What if he was wrong and the Canadian price rose? Let’s say instead of falling to 96, the cash price rose to 98. He would have had a $2,000 loss in the futures, but odds favor the Canadian portfolio increasing in value, too.

Options can be just as prudent and they offer something else, a sweetener: the possibility of improving on a position while limiting the risk for a predetermined cost. 

You could purchase an option giving you the right to sell CADs at, say, 96 cents to the dollar in six months for 150 basis points, a 96 put. A standard option contract traded at the Chicago Mercantile Exchange is for 100,000 Canadian dollars. The minimum tick is for $10.00 per contract, so a quote of 150 points will cost you $1,500–profit insurance, so to speak. 

If the Canadian dollar rises above 96, you lose the premium but can reap an additional currency profit theoretically unlimited. If the CAD falls, you sell your put for a profit, and this will offset the cheaper currency.

You would be willing to pay this $1,500 (your maximum risk), which will reduce your bottom line profit to assure a profit. Easier and cheaper than selling your Canadian trusts, and by holding them you continue to receive your distributions.

Is now a good time to hedge the Canadian dollar? 

For years now I’ve looked for the Canadian to trade back to par with the US dollar, and I still hold to this prediction. The trend remains up, and my Canadian dollar trade recommendations in my trading service Futures Market Forecaster (http://www.futuresmarketforecaster.com) have been from the long side (which would be a speculation for Canadian income trust investors).

Let’s look at this from the other side. If you’re a US investor in Roger’s portfolio, a rise in the value of the Canadian dollar will increase the returns in two ways: the monthly distributions (and Roger tells me they can be quite substantial) as well as beefed-up Canadian income trust share prices.

Canadian Dollar 1998 – Present

Source: Commodity.com

Remember, hedgers aren’t trying to make a killing in the market. Rather, they wish to offset price risks.

On the other hand, the speculator’s objective is to make money by buying low and selling high (or vice versa). It’s just as easy to buy the Canadian dollar in the futures market as sell it, however be aware that as a Canadian trust investor you’d be speculating when a buyer. This is because as a Canadian dollar buyer you’d make money on a long futures contract (or a call option position) and also on your Canadian investments simultaneously, but if the currency fell you could lose on both. 

For example, if you buy a contract at 96 and sell at 99 your gross profit would be $3,000 per futures contract. 

You say you don’t wish to be a speculator? Well, I have news for you: Even if you’re not in futures, if you’re a Canadian trust investor you already are because you’re implicitly betting the price of the Canadian dollar will continue to rise.