Currency Overlay

A currency overlay is an investment arrangement in which the currency exposure created by an international portfolio is managed separately from the choice of the underlying stocks, bonds or other assets. A pension fund, for example, may hire several equity and bond managers to pick foreign securities and a separate overlay manager to decide how much of the resulting foreign currency exposure to hedge back into the fund's home currency. The overlay usually uses forward contracts and does not buy or sell the underlying assets.

Overlays are used mainly by large institutional investors, such as pension funds, endowments, insurers and sovereign funds. They separate two decisions that are easily mixed up: which foreign assets to own, and how much foreign exchange risk to bear. The overlay mandate is normally set out in the investor's investment policy statement.

Suppose a family buys a holiday flat abroad. Two questions follow. Was the flat a good buy? And what happens if the foreign currency falls, so the flat is worth less in the family's own money even though local prices have not changed? The family might ask an estate agent about the first question and a currency adviser about the second.

A currency overlay does the same for big investment funds. The people who choose the foreign shares and bonds focus on picking good investments. A separate specialist looks only at the currencies involved and decides how much protection to buy against currency swings, adjusting it over time without touching the shares and bonds themselves.

The overlay manager receives regular reports of the portfolio's currency exposures, by currency and amount. It then sells foreign currencies forward against the home currency to reach the agreed hedge ratio, which is the proportion of foreign exposure to be hedged. Forwards are typically one to three months long and are rolled at maturity; when they settle, gains or losses are paid in cash. As the value of the underlying assets changes, the manager adjusts the hedges so the ratio stays within agreed bands.

The cost or benefit of hedging depends mainly on the interest rate differential between the two currencies, which is reflected in foreign exchange forward points. Approximately:

A US investor hedging euro assets when US dollar rates are 4 per cent and euro rates 2 per cent gains roughly 2 per cent a year from the forward premium, while a euro investor hedging dollar assets in the same conditions pays roughly 2 per cent.

• Passive overlay. The manager keeps the hedge ratio at a fixed benchmark, such as 50 or 100 per cent, aiming only to reduce risk at low cost.
• Active overlay. The manager varies the hedge ratio, or takes positions against the benchmark, to add return from currency views, within limits measured against a currency benchmark.
• Dynamic or rules-based overlay. The hedge ratio changes according to signals such as trends, valuation or interest differentials, often using systematic models.

An overlay brings currency risk under one specialist, nets exposures across many asset managers and avoids each manager hedging in a different way. It gives the investor control over the hedge ratio as part of asset allocation. The main practical challenge is liquidity: when the home currency weakens sharply, hedges lose money and must be settled in cash, so the investor needs a cash buffer or the ability to sell assets, which can conflict with rebalancing plans. Investors must also manage counterparty limits with the banks that write the forwards and, under rules such as EMIR in the EU, collateral and reporting duties for the trades.

There is no consensus on the right hedge ratio. Hedging foreign bonds tends to reduce volatility substantially, because currency moves dominate their returns, while the case for hedging equities is more mixed and depends on the currencies involved. Active overlay managers have produced uneven results, and fees and transaction costs can erode any gains. Some investors therefore choose passive overlays with a fixed ratio and treat active currency management, if at all, as a separate return-seeking strategy similar to a carry trade. An overlay also only manages exposures that are reported accurately, so poor data on look-through holdings, such as funds that themselves invest abroad, can leave risks uncovered.