What is Currency Overlay?

International portfolios include assets denominated in various currencies. Like regular portfolios, these portfolios require funds managers to allocate the assets and choose the securities in which to invest. In addition, international portfolios need protection from unfavorable currency exchange rate movements and opportunities to benefit from favorable currency exchange rate movements. Currency overlay is an investment strategy used by overlay managers who specialize in managing the currency exposure of international investment portfolios. Currency overlay maximizes the performance of the portfolio by helping these specialists measure currency performance to determine strategies to minimize risk and maximize profit.

Specialist firms, known as currency overlay managers, handle the currency exposures of international investment portfolios. The portfolios use currency overlay to limit the risk from unfavorable movements in currency exchange rates and maximize the profit from favorable movements in currency exchange rates. Depending on the preferences of the investor, the overlay manager could focus more on hedging against the risks or speculating to obtain profits. Some of the institutions that use currency overlay include endowments, corporate firms and pension funds.

The overlay manager can usually tailor the currency management plan to meet the preferences of the investor. The investor can decide what percentage of the portfolio to invest in foreign assets, how much currency risk to take and whether to focus on minimizing risks or maximizing profits. These decisions dictate the degree of involvement of the overlay manager.

A passive currency overlay program involves removing some of the international investment portfolio's currency risk. An active currency overlay program involves an overlay manager actively changing the hedge ratio of the currencies based on expectations regarding future movements of exchange rates. If the manager of an active portfolio expects a currency to drop in value, he or she increases its hedge ratio to protect against losses. If the manager expects a currency to increase in value, he or she reduces its hedge ratio to profit from the currency exposure.

An active program for the portfolio would generally cost more than a passive program. Generally, if the manager has to use more resources, such as time and technology, to maximize the value of the portfolio, the currency overlay would cost more. The cost of currency overlay also depends on the number of currencies in the portfolio and the risk of each currency, the fluctuations of the assets and the frequency of currency rebalancing required. Other factors that can affect cost include the derivative products used to manage the portfolio's currency exposure and the degree of precision the investor wants.