What is 'Currency Overlay'

Currency overlay refers to an investor outsourcing currency risk management to a specialist firm, known as the overlay manager. This is used in international investment portfolios, usually by institutional investors, in order to separate the management of currency risk from the asset allocation and security selection decisions of the investor's money managers. Currency overlay seeks to reduce the currency-specific risks that come with investing in international equities. 

BREAKING DOWN 'Currency Overlay'

Currency overlay is a service that is meant to allow investors to find global stocks and bonds without having to factor in the impact that the host nation's monetary policy will have on their portfolio. The currency hedging being done by the overlay manager is being "overlaid" on the portfolios created by other money managers. 

Why Currency Overlay is Needed

Currency risk management is something all portfolios with direct international holdings deal with. If an investor in the U.S. holds Japanese stocks, and the yen and the dollar don't shift in relative value, then the profit or loss of the Japanese holdings is unaffected by currency fluctuations. This, however, would be rare, as currencies fluctuate in comparison to each other all the time. These fluctuations can be tracked back to economic releases, political developments, natural disasters and so on. So the same investor holding Japanese stocks will see a benefit if the U.S. dollar weakens against the Japanese yen, as any profit in the stock carries a currency premium with it. Of course, a strengthening of the U.S. dollar against the yen bites into any profit and exacerbates any losses on those same Japanese holdings.

In order to tame these extremes, global investors must hedge their portfolios against currency risk — that or be prescient about upcoming currency swings and reposition the global holdings accordingly. In practice, hedging is usually done through contracts or complementary forex trading. With large holdings spanning the world, hedging the portfolio can be as time consuming as investing it. Enter the currency overlay offered by specialist firms. Institutional investors can focus on investing, and the currency overlay manager will take care of the currency. 

Passive versus Active Currency Overlay 

A currency overlay can be passive or active. The passive currency overlay is a hedge over the foreign holdings, which is set up to shift the currency exposure back into the domestic currency of the fund. This locks in an exchange rate for the period of the contract, and a new contract is put in force as an older one expires. This flattens out currency risk without trying to capture any benefit from it. Active currency overlay seeks to limit the downside currency exposure while also increasing the returns from a favorable currency swing. If, going back to the example, the Japanese yen strengthens against the dollar, an active currency overlay will try to capture excess return from that movement rather than simply shifting it back to the base currency. To achieve these excess returns, a portion of the total portfolio is left unhedged, with the overlay manager making decisions on currency positioning to create opportunities for profit. 

  1. Overlay

    Overlay refers to a management style that harmonizes an investor's ...
  2. Currency Basket

    A currency basket is a group of currencies used to measure the ...
  3. Currency Risk

    Currency risk is a form of risk that arises from the change in ...
  4. Currency Pair

    The quotation and pricing structure of the currencies traded ...
  5. International Currency Exchange ...

    An international currency exchange rate is the rate at which ...
  6. Reciprocal Currency

    In the foreign exchange market, a currency pair that involves ...
Related Articles
  1. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  2. Investing

    Looking to Hedge on Currency Volatility? Consider...

    In an attempt to dampen down the impact of the stronger dollar, investors have been turning to currency hedged exchange traded funds (ETFs) in a big way.
  3. Investing

    3 Strategies to Mitigate Currency Risk (EUFX)

    Discover the often overlooked risk known as currency risk, and learn three strategies to mitigate or eliminate it in your portfolio.
  4. Trading

    Top 5 Hardest-Hit Currencies

    The value of a country's currency is dependent on many factors that will cause it to fluctuate, relative to other world currencies.
  5. Investing

    Hedge Against Exchange Rate Risk With Currency ETFs

    Currency moves are unpredictable and can have an adverse effect on portfolio returns. Find out how to protect yourself.
  6. Trading

    The 6 Most-Traded Currencies And Why They're So Popular

    Every currency has specific features that affect its underlying value and price movements in the forex market.
  7. Trading

    Exploring Non-Dollar Currencies For Forex Trading

    Learn how investments in foreign currencies can diversify your portfolio.
  8. Trading

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
  9. Investing

    Currency Positions You Can Take Now

    The foreign currency market is the largest financial market in the world, and investors in this market have many options.
  1. Why is the U.S. dollar shown on the top of some currency pairs and on the bottom ...

    All currencies are traded in pairs. The first currency in the pair is called the base currency while the second is called ... Read Answer >>
  2. What is foreign exchange?

    Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's ... Read Answer >>
  3. What types of companies benefit from reporting results utilizing constant currencies ...

    Understand constant currency figures, and explore some of the reasons why a company is likely to benefit from reporting using ... Read Answer >>
  4. How are international exchange rates set?

    International currency exchange rates display how much one unit of a currency can be exchanged for another currency. Currency ... Read Answer >>
  5. What are key economic factors that can cause currency depreciation in a country?

    Read about the causes of currency devaluation, and find out how to differentiate between relative and absolute currency devaluation. Read Answer >>
Hot Definitions
  1. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  2. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  3. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  4. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  5. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  6. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
Trading Center