Currency Overlay Defined

What Is a 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, 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. 

Understanding a Currency Overlay

A currency overlay is designed to mitigate the financial impact on an investment portfolio from exchange rate fluctuations or volatility when investing in international assets that are denominated in a foreign currency. The global currency market is the largest market in the world with $5 trillion exchanging between various currencies daily. Corporations, banks, central banks, investment firms, brokers, and institutional investors all play a role in the global currency market when they buy and sell assets in a foreign currency, which is a currency other than their local currency. Global trade, international loans, and investments are just a few of the transactions that can involve exchanging one currency for another at the prevailing exchange rate.

Many investment firms offer currency overlay services that are designed to reduce or eliminate exchange rate conversion losses when investing internationally. The currency hedging being done by the overlay manager is being "overlaid" on the portfolios created by other money managers. 

Why a Currency Overlay Is Needed

Currency risk management is a necessary process for most portfolios with direct international holdings. If an investor in the U.S. holds Japanese stocks, and the exchange rate between the Japanese yen and the U.S. dollar doesn'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.

Exchange Risk

Typically, many foreign investments involve an exchange of the home currency for the foreign currency of the country where the funds are being transferred to, resulting in a currency conversion. When the funds are brought back to the home country and converted back into the local currency, another exchange occurs at the prevailing rate at that time. The difference between the two exchange rates can result in a gain or a loss. As a result, investments can increase or decrease in value solely based on the exchange rate conversions–all else being equal.

For example, if a U.S. investor wires $100,000 to Europe to be invested and it converts at an exchange rate of $1.10 for each euro, it would equal 110,000 euros. Let's say the investor earned a 5% return on the investment and wired the money back to the U.S. However, the exchange rate fell to $1.05, which is a 4.76% decline in the rate (from $1.10) and wipes most of the gain on the investment. When considering the billions of dollars that are invested in foreign assets and securities over an extended period, those investments are at risk of significant losses merely due to fluctuations in exchange rates.

Event Risk

Exchange rate moves can be caused by many factors, including economic conditions, such as whether an economy is growing or contracting. Countries that are experiencing slower growth or a financial crisis can result in investment capital or money fleeing the country in search of more stable economies. As a result, the releases of economic indicators such as consumer spending, unemployment, gross domestic product (GDP), which is a country's growth rate all have an impact on exchange rates. Also, political developments and natural disasters can drive an exchange rate.

Central Banks

Those who perform currency overlay hedges pay close attention to central banks around the world, such as the Federal Reserve Bank. The Fed sets monetary policy for the U.S. by increasing or lowering interest rates. A country with higher rates tends to attract more investment capital–all else being equal. Countries, where their central bank is lowering rates, is an indicator of financial or economic challenges, which can lead to a flight of capital to other countries.

All of these events impact exchange rates and investments in those countries. Currency overlay hedges use financial products to help mitigate the impact that those events might have on an investment portfolio.

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 vs. 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 process locks in an exchange rate for the period of the contract and a new contract is put in force as an older one expires. The product typically used is called a forward contract and a forward flattens out currency risk without trying to capture any benefit from it. A forward merely locks in an exchange today for delivery of the currency via wire transfer at a predetermined date in the future.

For example, investors who send money to Europe to buy securities and convert those funds into euros can lock in the exchange rate for converting those euros back to dollars at a date in the future. Many passive overlay strategies are automated and hedge the exposure so that there is no speculation on the currency exchange rate move.

Conversely, active currency overlay hedging seeks to limit the downside currency exposure while also increasing the returns from a favorable currency swing. If going back to the example, the euro strengthens against the dollar; an active currency overlay will try to capture the 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.