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.