Currency Overlay – Strategies & Instruments

Currency overlay is an investment strategy employed by institutional investors to protect their portfolios from currency fluctuations.

The currency overlay manager first identifies the currency risk exposure of the portfolio, and then enters into currency hedging transactions to offset that risk.

Currency overlay can be used to hedge both:

• currency risk arising from investments denominated in foreign currencies, and
• the currency risk of domestic investments that are exposed to foreign currency movements through imports, exports, offshore business, and so on

While currency overlay is most commonly used by large institutional investors, it can also be employed by individual investors looking to protect themselves from currency volatility.

Currency-hedged mutual funds and exchange-traded funds (ETFs) offer a way for individual investors to get exposure to foreign markets without having to worry about the potentially adverse effects of currency fluctuations.

Key Takeaways – Currency Overlay

• Currency overlay is an investment strategy used by institutional and individual investors to protect portfolios from currency fluctuations, manage currency risk and provide currency diversification.
• Currency hedging techniques, such as currency forwards, futures, swaps, and options, are employed in currency overlay to offset currency risk exposure.
• Currency-hedged mutual funds and ETFs provide opportunities for individual investors to access foreign markets while mitigating the impact of currency fluctuations.
• However, currency hedging also comes with its own risks, including basis risk and rollover risk.

Currency hedging

Individuals and institutions who have exposure to bonds, equities, and other instruments denominated in foreign currency have currency risk in their portfolios.

To hedge this currency risk, investors can enter into currency hedging transactions.

There are a number of different currency hedging strategies that currency overlay managers can use to offset currency risk exposure.

Forwards and futures are popular currency hedging instruments. Other common currency hedging strategies include options and swaps.

Currency forward contracts

The most common currency hedging strategy is to enter into forward contracts.

A forward contract is an agreement to buy or sell a currency at a future date at a predetermined exchange rate.

By entering into a forward contract, the currency overlay manager is able to lock in an exchange rate for a future transaction, and protect the portfolio from adverse movements in the currency market.

For example, a currency overlay manager with a portfolio of US dollar-denominated assets can enter into a currency forward contract to sell euros at a future date.

If the value of the euro falls against the dollar, the currency forward contract will offset the loss in value of the portfolio’s euro-denominated assets.

Currency-hedged mutual funds and ETFs

Investors who want exposure to foreign markets but want to avoid the currency risk can invest in currency-hedged mutual funds and exchange-traded funds.

These types of funds hold a portfolio of securities and use currency hedging techniques to offset the currency risk.

Currency-hedged mutual funds and ETFs give investors the opportunity to participate in the potential upside of foreign markets without having to worry about the downside risk of currency fluctuations.

Investors should be aware that currency hedging comes with its own set of risks, including basis risk and rollover risk.

Basis risk is the risk that the currency hedge will not perfectly offset the underlying currency exposure.

Rollover risk is the risk that positions held in forward contracts will have to be closed out at a loss if the currency moves in an unfavorable direction.

Currency swaps

A currency swap is an agreement between two parties to exchange currency denominated in one currency for another currency.

Currency swaps are often used by currency overlay managers as a way to hedge currency risk.

For example, a currency overlay manager with a portfolio of US dollar-denominated assets can enter into a currency swap with a counterparty and exchange their US dollars for Japanese yen.

This would protect the portfolio from a decline in the value of the US dollar against the Japanese yen, wherever that exposure exists.

Currency swaps can be used to hedge against currency risk exposure in both foreign investments and domestic investments that are exposed to foreign currency movements.

Currency options

Currency options are another tool that currency overlay managers can use to hedge currency risk.

A currency option gives the holder the right, but not the obligation, to buy or sell a currency at a specified exchange rate on or before a certain date.

Currency options can be used to hedge against both foreign currency risk and domestic currency risk.

For example, a currency overlay manager with a portfolio of US dollar-denominated assets can purchase put options on the Japanese yen.

This would give the manager the right to sell Japanese yen for US dollars at a specified exchange rate on or before a certain date.

If the value of the Japanese yen declines against the US dollar, the currency overlay manager can exercise their option and sell Japanese yen for US dollars at a profit.

Currency futures contracts

Currency futures contracts also serve the same purpose and are similar to currency forwards.

A currency future is a contract to buy or sell a currency at a specified exchange rate on a certain date in the future.

Currency futures contracts are traded on exchanges and are used by currency overlay managers as a way of hedging currency risk.

For example, a currency overlay manager with a portfolio of US dollar-denominated assets can enter into a currency future contract to sell Japanese yen if there was the desire to hedge out any equivalent amount of yen exposure.

This would give the manager the right to sell Japanese yen for US dollars at a specified exchange rate on a certain date in the future.

If the value of the Japanese yen declines against the U.S. dollar, the currency overlay manager can exercise their contract and sell Japanese yen for US dollars at a profit equivalent to the favorable movement in the futures contract.

Currency forwards vs. futures

Like currency forward contracts, currency futures can be used to hedge currency risk exposure.

However, there are some key differences between currency forwards and futures.

One difference is that currency futures are traded on regulated exchanges, while currency forwards are not.

This means that currency futures are subject to exchange fees, while currency forwards are not.

Another key difference is that currency futures contracts are standardized, while currency forward contracts are not.

This means that currency futures contracts can be easily traded and exchanged, while currency forward contracts cannot.

Finally, currency futures contracts have expiry dates – they have to be rolled – while currency forward contracts do not.

This means that currency futures contracts must be settled on or before their expiry date, while currency forward contracts can be held until maturity.

Example of a Currency Overlay Trade

This strategy is typically employed by institutional investors like pension funds, endowments, and multinational corporations with large international exposure.

Here’s a hypothetical example to illustrate how a currency overlay trade might be executed:

Background

• Institutional Investor: A US-based pension fund.
• Portfolio: Diversified investments in European and Asian markets.
• Currencies Involved: Primarily Euro (EUR) and Japanese Yen (JPY) against the US Dollar (USD).
• Risk: Fluctuations in EUR/USD and JPY/USD exchange rates.

Objective

• Primary Goal: To protect the value of the portfolio against adverse currency movements, without altering the underlying asset allocations (passive management).
• Secondary Goal: Potentially profit from currency fluctuations (active management).

Implementation

Currency Risk Assessment

Analyze the currency exposure of the portfolio.

Suppose the fund has 40% exposure to EUR and 30% to JPY.

Hedging Strategy

Decide on the proportion of exposure to hedge.

For this example, let’s say the fund opts to hedge 50% of its EUR exposure and 70% of its JPY exposure.

Choosing Instruments

Select appropriate financial instruments for hedging.

Common choices include forward contracts, futures, options, and swaps.

Assume the fund uses forward contracts for EUR/USD and futures for JPY/USD.

(It will depend on the most cost-effective choice all-around.)

Trade Execution

• EUR/USD Forward Contracts: Enter into forward contracts to sell EUR and buy USD at a future date. The amount is 50% of the fund’s EUR exposure.
• JPY/USD Futures Contracts: Buy JPY/USD futures to hedge 70% of the JPY exposure. This locks in a future rate for converting JPY back to USD.

Monitoring and Rebalancing

Regularly monitor the portfolio and adjust the hedging positions as necessary based on market movements and changes in the portfolio’s currency exposure.

Possible Outcomes

If the USD strengthens against EUR and JPY

The losses in the portfolio due to the weakening of EUR and JPY are offset by gains in the hedging positions.

If the USD weakens against EUR and JPY

The gains in the portfolio are partially reduced by losses in the hedging positions, but the overall portfolio value in USD terms is protected.

Summary

This currency overlay trade allows the pension fund to manage currency risk efficiently while maintaining its strategic asset allocation across different geographies.

The key is to dynamically manage the hedge ratios and positions based on market conditions and portfolio performance.

Currency overlay as a means of diversification

Currency overlay can also be used to better diversify one’s currency exposures.

Most portfolios are heavily biased to be long a certain asset class, all denominated in the same currency.

Capital isn’t so much destroyed in markets (i.e., when asset classes fall), but shifts to other things.

It’s always shifting between different assets, asset classes, countries, currencies, and financial and non-financial stores of value.

This makes the case for not having a portfolio entirely in a single currency as a means of prudent diversification.

Currency overlay using gold

Currency overlay managers can also use gold to hedge currency risk.

Gold is traditionally seen as a safe haven asset and is used by investors to protect against currency risk.

For example, gold can be used to hedge currency risk in a portfolio of assets denominated in any currency.

If the value of a currency falls (e.g., against other currencies, lower real yields), the value of gold will typically increase simply because its price is a reflection of the value of the money used to buy it.

Gold is something that is not anybody else’s liability, unlike financial wealth where someone has to make due on the claim.

A strong domestic currency might mean a falling gold price simply because the value of money is rising relative to alternative stores of value.

Many portfolio managers use gold as a currency overlay in an allocation of somewhere around 5 to 15 percent.

And without taking away from other assets in the portfolio (e.g., not selling equities or other assets just to buy gold, but perhaps simply buying gold through the futures market or another method).

Other currencies can be used similarly

A US-based trader or investor will have their portfolio in dollars.

Currency overlay can be accomplished with other currencies, such as buying foreign assets denominated in other currencies, diversified commodities baskets, or simply having spot FX exposure.

A trader could have currency overlay exposures to various currencies (e.g., EUR, GBP, JPY, CAD, AUD, CHF, gold, emerging market currencies, and so on).

These would not serve as core portfolio positions (i.e., exposures to them would be small), but to help diversify currency exposure in a portfolio.

Risk Parity with Currency Overlay

Risk parity and currency overlay strategies represent two distinct but complementary approaches in portfolio management and international investing.

Risk Parity

Risk parity is a portfolio allocation strategy that focuses on allocating capital based on:

• the risk (typically measured by volatility) contributed by each asset class, or
• how they contribute to various macro environments based on their environmental biases…

…rather than on expected returns or capital allocation.

The goal is to balance the risk contributions of different assets, rather than their dollar allocations.

Related: Balanced Beta

Implementation

In practice, risk parity involves:

• Risk Assessment: Identifying the risk (volatility) of each asset class.
• Correlation Analysis: Understanding how different asset classes interact, especially under different market conditions.
• Leverage Adjustment: Often, leverage or leverage-like techniques (futures, options) are used to amplify the returns of lower-risk assets to make their risk contribution comparable to higher-risk assets.

This approach aims to create a more stable portfolio that is less dependent on the performance of any single asset class. 

It’s favored in environments where predicting asset returns is challenging (or when that approach is unwanted).

Currency Overlay

As mentioned, currency overlay is a strategy used primarily by institutions or investors with international portfolios. 

It involves managing the currency risk independent of the underlying asset management. 

This strategy can be important when investing across multiple countries with different currencies.

It involves:

• Currency Risk Assessment: Identifying and measuring the currency exposure of international investments.
• Hedging Strategies: Using financial instruments like forwards, futures, and options to hedge against currency risk.
• Active vs. Passive Management: Deciding whether to actively manage currency exposure for additional returns (active management) or just to neutralize the currency risk (passive management).

Integration with Risk Parity

When combined with risk parity, the currency overlay approach can add another layer of risk management.

In a risk parity framework, currency risks can be quantified and managed alongside other asset class risks.

This ensures that currency fluctuations do not disproportionately affect the overall portfolio risk.

Synergy

Integrating risk parity with currency overlay involves managing both asset and currency risks in a coordinated manner. 

This means:

• Adjusting the portfolio to account for both the inherent risk of the assets and the associated currency risks.
• Leveraging statistical models to understand the interaction between asset prices and currency movements.
  • And how these relationships might change under different economic conditions.
• Using Monte Carlo simulations and other probabilistic techniques to forecast potential outcomes and optimize the portfolio accordingly.

Combining these strategies allows for a more holistic view of risk management.

It combines both the internal dynamics of the portfolio and the external currency influences, which is important for international investments.

Conclusion

Currency overlay is an investment strategy that involves actively managing a portfolio’s currency exposure separate from the underlying assets.

The goal is to generate additional returns or hedge against adverse currency movements by taking advantage of movements in currency exchange rates.

Here are some key points about currency overlay:

• It involves separating out the currency component from the underlying investments. For example, if a US investor owns shares in a French company, the shares represent both exposure to the company’s performance as well as exposure to fluctuations in the euro/dollar exchange rate.
• With a currency overlay, the currency exposure is isolated and can be actively managed without having to buy or sell the underlying assets. This is often done using currency forward contracts.
• It provides a way to hedge currency risk in a portfolio without having to liquidate investments or avoid opportunities in certain markets. Investors can maintain their desired asset allocation while adjusting the currency exposures.
• Active currency management aims to profit from anticipated changes in exchange rates based on macroeconomic and geopolitical factors. Currencies tend to exhibit trends and cycles that can be analyzed and traded upon.
• The overlay can be tailored to a trader’s objectives, such as reducing overall portfolio volatility or increasing returns. It can also be used speculatively to take outright positions in currencies.
• Overlay strategies are often implemented by specialized currency managers. They require expertise in economic forecasting, political risks, and trading to successfully actively manage currency exposures.
• As with any active strategy, the success of a currency overlay relies on the skill of the manager and there is risk of losses if currencies do not move as expected. Appropriate due diligence is required.

In short, currency overlay allows separating currency management from core portfolio holdings using derivatives and other instruments. Currency forwards, currency swaps, currency options, and currency-hedged mutual funds and ETFs are all tools that investors can use to offset currency risk exposure.

It provides flexibility to manage currency risk and potential added returns from currency positions.

It may involve strategies that use a mix of currencies to offset the risks posed by any one currency.

Currency overlay can be used to protect against currency risk, or it can be used to take advantage of expected changes in currency values.

Gold is often used as a currency overlay because it is seen as a safe haven asset.

Other currencies can also be used as currency overlays.

Each currency overlay strategy has its own advantages and disadvantages, and each should be used in a way that is appropriate for the trader or investor’s individual circumstances.