In fact, stock investors are increasingly using currencies to hedge against risks with their stock portfolios. However, the problem with doing this is they have to manage their currency and stock investments separately, making this sort of diversification difficult to handle. New currency exchange-traded funds (ETFs) eliminate this problem. With a currency ETF, an ETF management firm buys currency pairs and holds them in a fund. The firm then sells shares in the ETF to individual investors, who can then buy and sell them in just the way that they buy and sell stocks. As the currency pair arises, the corresponding share price rises in tandem, and the share price falls as the currency falls.
To understand why investors are interested in using currencies rather than just buying other shares, it is important to know the different types of risk in the stock market. The first is what is known as idiosyncratic risk – the risk that any particular stock will fall. For instance, if a company reports poor results, the stock price will typically fall, even if its competitors are doing well. This type of risk can be managed by buying a broader basket of stocks. However, there is also systematic risk – the risk that the entire stock market will fall. You only need to look at the initial effects of the recent world economic crisis to see this type of risk in action.
Buying a broader range of stocks doesn’t combat systemic risk. However, investing in currencies can do exactly this. For example, consider the Swiss franc. In general, history has shown that the Swiss franc rises against the US dollar when bond yields fall. Since falling bond yields generally happen when the stock market falls, holding a position in CHF/USD can hedge against the risk of a bear market. Similarly, the Canadian dollar tends to rise as oil prices rise, since Canada is a major oil producer. Because of this, investing in a CAD/USD ETF can be used to hedge against the impact of higher energy prices on the stock market.
Editors’ Picks
EUR/USD clings to recovery gains near 1.0850 ahead of Fedspeak
EUR/USD trades in positive territory near 1.0850 on Friday following a four-day slide. China's stimulus optimism and a broad US Dollar correction help the pair retrace the dovish ECB decision-induced decline. All eyes remain on the Fedspeak.
GBP/USD pares UK data-led gains at around 1.3050
GBP/USD is trading at around 1.3050 in the second half of the day on Friday, supported by upbeat UK Retail Sales data and a pullback seen in the US Dollar. Later in the day, comments from Federal Reserve officials will be scrutinized by market participants.
Gold at new record peaks above $2,700 on increased prospects of global easing
Gold (XAU/USD) establishes a foothold above the $2,700 psychological level on Friday after piercing through above this level on the previous day, setting yet another fresh all-time high. Growing prospects of a globally low interest rate environment boost the yellow metal.
Crypto ETF adoption should pick up pace despite slow start, analysts say
Big institutional investors are still wary of allocating funds in Bitcoin spot ETFs, delaying adoption by traditional investors. Demand is expected to increase in the mid-term once institutions open the gates to the crypto asset class.
Canada debates whether to supersize rate cuts
A fourth consecutive Bank of Canada rate cut is expected, but the market senses it will accelerate the move towards neutral policy rates with a 50bp step change. Inflation is finally below target and unemployment is trending higher, but the economy is still growing.
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