As an investor with assets denominated in various currencies, your portfolio requires protection from currency exchange rate movements. Currency overlay is an investment strategy used in managing the currency exposure and aims to separate the management of currency risk from the asset allocation and security selection decisions of the investor.
At its core, currency overlay strategies involve hedging the currency exposure created by a foreign investment through the use of foreign exchange forward contracts. The combination of foreign exchange forwards with foreign assets allows the risks to be managed separately.
If risk reduction is the primary objective of your currency overlay, then a passive strategy is most suitable. As the name implies, it involves putting on a forward contract that is a fixed percentage of the fund’s net asset value and then leaving that hedge percentage constant over the life of the investment. Periodic rebalancing occurs only if the fund’s net asset value is adjusted.
The passive overlay provides stability if its primary objective is to reduce fund volatility from currency movements.
Unlike a passive approach, the active currency manager is given discretion to vary the hedge percentage, with the aim of beating their benchmark. Active overlay strategy seeks non-correlated returns (alpha) from currency risk.
An active currency overlay 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 will increase its hedge ratio to protect against losses. If the manager expects a currency to increase in value, he will consequently reduce its hedge ratio to profit from the currency exposure.
Keep in mind, it makes little sense to hedge foreign currency exposure if the investor has a strong conviction that the foreign currencies to which he has exposure will appreciate versus his base currency.