Canadian Securities Course (CSC) Level 2 Practice Exam

What is the primary purpose of using currency hedging in ETFs?

1. To increase currency risk

2. To offset market risk

3. To reduce tracking error

4. To offset the short position monthly

The correct answer is: To offset market risk

The primary purpose of using currency hedging in exchange-traded funds (ETFs) is to mitigate the impact of currency fluctuations on the returns of the fund. This is particularly relevant for ETFs that invest in assets denominated in foreign currencies. By hedging currency risk, an ETF can protect its investors from adverse exchange rate movements that might otherwise erode returns when the fund is converted back into the investor's home currency. Currency hedging aims to stabilize returns in the investor's currency, hence it does not intend to increase currency risk. Instead, it proactively manages that risk to maintain predictable performance relative to the underlying assets. Offsetting market risk generally pertains to broader market fluctuations rather than specific currency movements. Reducing tracking error pertains to how closely the ETF follows its benchmark index, which may not be directly related to currency exposure. The reference to offsetting short positions monthly is more specific to strategies involving derivatives, which does not capture the essence of currency hedging in general markets. Thus, mitigating currency risk aligns closely with the main goal of hedging practices in ETFs.