How Heart & Crown Capital Performs Currency Hedging: A Case Study

Introduction

In an increasingly globalized financial market, currency risk has become a significant concern for investors. Currency fluctuations can have a substantial impact on investment returns, especially when dealing with investments in foreign currencies. Heart & Crown Capital understands the importance of managing this risk and employs sophisticated currency hedging strategies to protect clients' investments. This blog post will explore how Heart & Crown Capital performs currency hedging and provide a detailed example of a two-year investment that needs to be done in Canadian dollars (CAD) with monthly CAD interest payments, despite the investor being a US dollar (USD)-based investor who wants to invest only in USD.

What is Currency Hedging?

Currency hedging is a risk management strategy used to protect investments from the adverse effects of currency fluctuations. By locking in exchange rates or using financial instruments to mitigate the risk, investors can ensure more predictable returns and protect their capital from unfavorable currency movements.

How Heart & Crown Capital Performs Currency Hedging

1. Forward Contracts: Agreements to exchange a specific amount of one currency for another at a predetermined rate on a future date.
2. Currency Swaps: Agreements to exchange currency cash flows between two parties over a specified period.
3. Options: Financial derivatives that provide the right, but not the obligation, to exchange currency at a specified rate before a certain date.
4. Natural Hedging: Structuring investments to offset currency exposure naturally, by matching currency inflows and outflows.

Case Study: A Two-Year Investment in Canadian Dollars

Scenario: A US-based investor wants to invest in a two-year CAD-denominated bond that pays monthly interest in CAD. The investor wants to invest only in USD and seeks protection from exchange rate fluctuations between USD and CAD.

Step-by-Step Hedging Process

1. Investment and Currency Exposure

• Investment: The investor commits USD 1 million to purchase a two-year CAD-denominated bond.
• Currency Exposure: The bond is denominated in CAD, with monthly interest payments also in CAD.

2. Determining the Hedge Ratio

• Hedge Ratio: To fully hedge the investment, Heart & Crown Capital calculates the total expected CAD cash flows, including both the principal and interest payments.

3. Implementing a Forward Contract

• Forward Contracts: Heart & Crown Capital enters into a series of forward contracts to lock in the USD/CAD exchange rate for the duration of the investment. This involves setting up contracts for the principal amount and the monthly interest payments.
• Example: Assume the current exchange rate is 1 USD = 1.25 CAD. The forward contracts lock in this rate for the investment period.

4. Monthly Interest Payments

• Interest Payments: Each month, when the bond pays interest in CAD, Heart & Crown Capital uses the forward contracts to convert the interest payments to USD at the pre-agreed rate. This ensures the investor receives consistent USD payments regardless of exchange rate fluctuations.

5. Maturity and Principal Repayment

• Principal Repayment: At the end of the two-year period, the forward contract for the principal amount is executed, converting the CAD principal repayment back to USD at the locked-in rate.

Example Calculation

Investment Details:

• Principal: CAD 1,250,000 (equivalent to USD 1,000,000 at the exchange rate of 1 USD = 1.25 CAD).
• Annual Interest Rate: 5%
• Monthly Interest Payment: CAD 5,208.33 (CAD 1,250,000 * 5% / 12)

Hedging Strategy:

• Forward Contracts: Lock in the exchange rate of 1 USD = 1.25 CAD.
• Monthly USD Interest Payments: USD 4,166.67 (CAD 5,208.33 / 1.25)

Benefits of Currency Hedging with Heart & Crown Capital

1. Predictable Returns: By locking in exchange rates, Heart & Crown Capital ensures that the investor receives consistent returns in their base currency (USD), eliminating the uncertainty caused by currency fluctuations.
2. Risk Management: Effective hedging protects the investor’s capital and income stream from adverse exchange rate movements.
3. Tailored Solutions: Heart & Crown Capital provides customized hedging strategies based on the specific needs and goals of each investor.

Conclusion

Currency hedging is an essential tool for managing the risks associated with foreign investments. Heart & Crown Capital’s expertise in currency hedging allows US-based investors to invest in foreign assets, like Canadian bonds, without worrying about exchange rate fluctuations. By employing forward contracts and other hedging techniques, Heart & Crown Capital ensures that investors can achieve their financial goals with greater confidence and security. Whether you're looking to invest internationally or manage currency risk, Heart & Crown Capital offers the solutions and expertise to safeguard your investments.