The montreal exchange is creating a new product aimed at retail investors who are being stung by the rising value of the Canadian dollar. The ME is seeking regulatory approval to introduce options on the U.S. dollar and the euro, a product designed to allow individual investors to hedge their foreign investments against currency volatility.

Canadian investors have watched helplessly as a 30% jump in the value of the loonie against the US$ in the past two years has wiped out gains on investments south of the border.

“When we’ve talked to the retail community — both individuals and investment advisors — we’ve had strong requests for a tool for hedging portfolios, primarily in U.S. assets,” says Glenn Goucher, the ME’s senior vice president of financial markets. “There is nothing for an individual right now for managing currency.

“What we are effectively allowing people to do is buy insurance against the currency, so it is not part of the investment decision,” he says.

An option will have a nominal value of $10,000 or 10,000 euros per contract. The exercise prices and option premium quotations will be in C$, and the options’ expiration dates will go out for nine months.

The ME offers the following example of the cost of one option: if a US$ option with an underlying value of US$10,000 is purchased at a premium of C75¢, the cost of the option would be C$75 plus trading commissions.

An investor seeking to hedge a portfolio of U.S. investments against a strengthening C$ would purchase US$ call options that would give him or her the right — but not the obligation — to purchase, or “call,” US$ at a fixed price.

If the C$ did strengthen, the investor would be compensated by the rising value of the option.

If the value of the C$ decreased, the investor would allow the option to expire and forfeit the premium paid to purchase it.

“We have carefully [researched] a product designed for the retail marketplace,” Goucher says.

The product should be attractive to users other than investors: small-business owners, people looking at foreign real estate investments, parents paying tuition at foreign universities and people planning expensive trips.

Canadian banks already do a roaring business in over-the-counter currency hedging, but primarily for large corporate customers. “The banks are very keen on it for corporations and pension funds,” Goucher says. “They’re not keen on it for individuals.”

In a background paper, the ME states that currency hedging activities by Canadian businesses have increased about 30% in the past year, and the amount of over-the counter (non-exchange-traded) currency options increased 51% annually from December 2001 to December 2003.

It also suggests retail investors have been hurt by fraud in the unregulated over-the-counter currency options market.

Goucher says retail investors seeking over-the-counter forward currency hedging are often confronted by “opaque” pricing.

The ME has lined up professional market-making firms to post markets on the options throughout the day. Goucher declined to identify the firms, except to say they are not linked to the banks.

The ME no doubt hopes the product does better than its 2001 bid to be the first North American exchange to offer single-stock futures. The exchange had plans for a series of stock futures and kicked things off in January 2001 with a contract on Nortel Networks Corp. stock. With the bursting of the tech bubble, the product flopped and the Nortel contract was shelved about two years ago. The ME has had better luck with another recent product — options on iUnit sector exchange-traded funds, he says.

The ME is aiming for volume of 1,000 contracts a day for its currency options. “With new products … we take a good idea that makes sense and we try it to see if it works,” he says. “If we had a contract that traded a 1,000 times a day, that would be very successful for us.”

Montreal broker Richard Briggs anticipates the new options contracts will be well received by investors as long as market-makers ensure adequate liquidity.
“Just about everybody in Canada has some kind of U.S. currency issue,” says Briggs, vice president of Refco Futures (Canada) Ltd. “Investors will increasingly be trading in the U.S. market, and companies either have U.S. customers or U.S. suppliers.”

Briggs welcomes news that the options will be settled in C$. Many brokers refuse to trade Philadelphia Stock Exchange currency options because of headaches with settling in foreign currency.