Reader Question: How to Protect Yourself against the Dropping Canadian Dollar

A thoughtful reader asked me about how Canadians can protect themselves against our dropping Canadian Dollar. I won’t name this reader because I intend to answer this question more forcefully and bluntly than usual. This may come across as wrath against this particular reader but that isn’t my intention. I want to shake up people’s thinking.

Here is the beginning of the (lightly edited) question:

Predictions abound that the Canadian dollar will drop in value relative to the U.S. dollar. This might be due to the overall economic forces, or maybe the election of PQ and the Neverendum issue.

First of all, “Neverendum” is clever; kudos to whoever thought of it first. Next I have a message for the people of Québec: Don’t listen to the vocal minority in the rest of Canada. We love you. Please don’t go.

Predictions about the Canadian dollar are worthless. Do you seriously believe that Canada’s current economic and political issues have somehow escaped the attention of the people who collectively risk not millions, not billions, but trillions of dollars in currency markets?

Confident speakers can sound persuasive on either side of the question of which way the dollar will go. They’re going to be right half the time, but that doesn’t mean they have any useful insight. Suppose I say “heads and the dollar goes up, tails it goes down.” Then I toss heads and the dollar happens to go up. Does this mean I was right? Does it mean the coin was right? No and no. My prediction was worthless along with all the other smarter-sounding predictions.

The sooner we all admit that we don’t know what will happen to the dollar, the sooner we can stop putting ourselves at risk of making foolish bets.

Presumably sophisticated investors can protect against the dropping dollar. Maybe people planning a vacation in the U.S. and would like to protect themselves against a big drop in Canadian dollar.

Sophisticated investors can make a bet that the Canadian dollar will drop. Unsophisticated investors can make similar bets. However, once you admit you don’t know what will happen to the dollar, you start to think about reducing uncertainty. This means that you reduce the risk of loss if the dollar drops, and you also give up the possibility of a gain if the dollar rises.

Protecting against the downside while keeping all of the upside cannot be done. You can use certain types of derivatives to reduce downside volatility, but they have a cost. Anything that looks like insurance always has a premium to pay. It’s better for the typical person to think about lowering uncertainty rather than just eliminating the down side.

Perhaps we could put cash in a U.S. dollar savings account at a local bank (and pay retail exchange rates). Or should people with a brokerage account buy a cross-listed stock and hold it in U.S. dollars instead of Canadian dollars?

Now we’re on the right track. If you want protection against the uncertainty of holding Canadian dollars but having expenses in U.S. dollars, the solution involves holding assets that depend on the U.S. dollar.

There are two separate issues here. One is how to keep exchange rates down when exchanging Canadian dollars for U.S. dollars. The other question is what assets you should hold.

Currency Exchange

The key to currency exchange is to plan ahead so you don’t do it too often. It’s expensive enough to exchange some money once without bouncing the same lump of cash back and forth several times. The costs are hidden in the exchange rate. There is a gap between the rate you get going from Canadian to U.S. and the rate you get going from U.S. to Canadian. This gap means that a “round-trip” from Canadian to U.S. and back again leaves you with less money than you started with.

No matter what method you use to do currency exchange, there will be an exchange-rate gap that costs you money. For small transactions, it’s hard to do much better than the rates you get at the big banks. However, for those with self-directed trading accounts, consider learning about the Norbert Gambit.

What U.S. Assets Should You Hold?

For near-term expenses, cash makes a lot of sense. U.S. dollar savings accounts or the U.S. side of discount brokerage accounts make sense. For snowbirds with longer-term expenses, consider assets like U.S. stocks and bonds.

However, be sure that the assets you choose are actually depend primarily on the U.S. dollar. The specific example of using a cross-listed stock does not work. Take the example of Royal Bank stock. Whether you own RY on the TSX in Canadian dollars or RY in the U.S., you own exactly the same asset. You will be exposed to the same currency-related risks no matter which version of RY you buy. The particular currency you use to buy a stock isn’t necessarily the same as the currency that most influences the underlying business.

If you wish to own stocks and bonds that depend primarily on the U.S. dollar and denominated in U.S. dollars, one place to look is Vanguard exchange-traded funds which can be purchased from a Canadian brokerage account. There are a few things to watch out for if you decide to try this route:

Hidden currency exchanges: If your Canadian brokerage account only holds Canadian dollars, you may be paying currency exchange costs every time you buy or sell an ETF denominated in U.S. dollars.

Proper Financial Plan: Make sure that whatever you own in U.S. dollars works with the rest of your assets to form a sensible and consistent financial plan.

U.S. Estate Taxes: People whose entire estate (not just the U.S. part) is large enough can be subject to U.S. estate taxes on death.

As with many things in life, making sensible choices about protecting yourself against the dropping Canadian dollar starts with understanding. The right course of action follows from that understanding.