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. 

RELATED TERMS
  1. Currency ETF

    Currency ETFs (exchange-traded funds) aim to replicate movements ...
  2. Currency

    Currency is a generally accepted form of money, including coins ...
  3. Base Currency

    The first currency quoted in a currency pair on forex. It is ...
  4. Currency Risk

    Currency risk is a form of risk that arises from the change in ...
  5. Weak Currency

    A weak currency is one whose value has depreciated significantly ...
  6. Accounting Currency

    Accounting currency is the monetary unit used when recording ...
Related Articles
  1. Personal Finance

    How Lender Overlays Prevent Mortgages

    Loan applications are increasingly being rejected because of lender overlays.
  2. Trading

    The Effects Of Currency Fluctuations On The Economy

    Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies.
  3. 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.
  4. 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.
  5. Trading

    The Forex Market: Who Trades Currency And Why

    The forex market has a lot of unique attributes that may come as a surprise for new traders. Learn more about who trades foreign currencies and why.
  6. Trading

    Drastic Currency Changes: What's The Cause?

    Currency fluctuations often defy logic. Learn the trends and factors that result in these movements.
  7. 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.
  8. Trading

    How To Avoid Exchange Rate Risk

    What are the best strategies to avoid exchange rate risk when trading?
RELATED FAQS
  1. How often do exchange rates fluctuate?

    Exchange rates float freely against one another, which means they are in constant fluctuation, as they are driven by demand. Read Answer >>
  2. 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 >>
  3. Why isn't the EUR/USD currency pair quoted as USD/EUR?

    In a currency pair, the first currency is called the base currency and the second is the quote currency, a longtime convention ... Read Answer >>
  4. How are international exchange rates set?

    Knowing the value of your home currency in relation to different foreign currencies helps investors to analyze investments ... Read Answer >>
Hot Definitions
  1. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  2. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  3. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  4. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  5. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  6. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
Trading Center