What is Currency Overlay?
Currency overlay is an investment risk management strategy usually implemented by specialist firms that manage foreign currency exchange risk for client investors. The clients may be individual investors, mutual funds, or large institutional investors such as pension funds or insurance companies.
Currency overlays can be an important risk hedging tool for investors who hold significant amounts of foreign stocks or other investments that can be impacted by fluctuating currency exchange rates. The use of firms that offer currency overlay management only originated in the mid-1980s. It has expanded substantially, as the financial world becomes more internationally integrated, thus leading to investors holding more investments in foreign equities.
Currency overlay risk management strategies may be either passive or active (described below). In addition to hedging currency exchange risk, some investors employ currency overlay strategies to maximize gains in foreign investments.
- Currency overlay is an investment risk management strategy, usually implemented by specialist firms that manage foreign currency exchange risk for client investors.
- Currency overlays can be an important risk hedging tool for investors who hold significant amounts of foreign stocks or other investments that can be impacted by fluctuating currency exchange rates.
- Overlay strategies may be passive (merely seeking to hedge risk) or active (looking to generate additional investment returns).
The Mechanics of Currency Overlay
Many different types of investors – from individuals to institutional investors – hold stocks, bonds, or other investments that are denominated in foreign currencies. As such, currency exchange rate fluctuations can significantly impact the value of their investments.
For a simple example, assume that an investor in the United States holds an investment in a foreign stock that has appreciated in value 10%. However, if the exchange rate between the US dollar and the foreign currency that the stock is denominated in has declined 12% against the US dollar, then when the investor sells the stock and converts the cash received back into US dollars, rather than realizing a 10% profit, they will instead have suffered a net loss of 2%.
Currency overlay strategies are implemented using financial instruments such as currency forward contracts, futures, and foreign exchange (forex) trading. Firms that offer currency overlay management continually monitor the overall economy of relevant foreign countries, as well as central bank policies that govern the prevailing interest rates in each country.
Currency overlay strategies must also take into account the particular situations and needs of the investor on whose behalf the strategies are implemented. For example, if a currency overlay management firm is handling currency exchange risk for a mutual fund portfolio, it must consider when and how often the portfolio is rebalanced and the fund’s cash flow needs.
Passive Currency Overlay
A passive currency overlay plan is strictly aimed at eliminating or mitigating currency exchange risk. It is not designed to potentially generate additional profits from changes in exchange rates, but only to hedge against potential losses.
The overlay manager typically executes the plan using one or more currency forward contracts that lock in the relevant currency exchange rate at a specified level. By doing so, the money in foreign investments is essentially maintained in the home currency of the investor, as future currency exchange rate fluctuations will not impact the value of the investments.
Active Currency Overlay
In contrast to passive currency overlay strategies, an investor may opt for an active overlay strategy. Active overlay strategies still aim to hedge exchange rate risk for an investor; however, it leaves part of the investor’s portfolio unhedged.
The unhedged portion of the portfolio is then actively managed in relation to fluctuations in currency exchange rates, with the purpose of garnering additional profits for the portfolio from such fluctuations. The active type of currency overlay strategy is typically executed with active foreign exchange, futures, or options trading. The potential to obtain additional investment returns through currency exchange trading is sometimes referred to as the “alpha component.”
The amount of the investor’s portfolio holdings that are left unhedged and actively managed for potential profit is determined by the level of risk the investor is comfortable with and may be periodically adjusted by the overlay manager according to changing market trends, interest rate changes, or other market factors.
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