What are "overlay strategies" in the buy side?
Used by hedge funds and asset management firms.
Can someone describe what exactly that is?
I was talking to someone earlier and these buy side firms have overlay strategies and need to sometimes hedge this. For example, let's say they want to buy Eurobonds and to do that they need to buy Euros to make these purchases. As the eurobonds goes up or down in value, they need to hedge their overlay strategies.
So let's say in your instance that a US portfolio manager invests in Eurobonds in his fund, which is the primary mandate of the fund, however given the PM's background he does not have the expertise to manage the currency exposure he's implicitly assuming by investing in Eurobonds. He could then have an overlay strategy implemented, which specifically manages that EUR currency exposure. It's called an overlay strategy because it's not the primary focus or expertise of the primary fund manager, and instead done by an external manager or another specialist team in-house that does have that expertise. This currency overlay strategy then serves to either hedge the EUR exposure completely, or to partially hedge it thus taking bets on the EUR/USD exchange rate.
Thanks for the explanation.
And if the PM buys EUR/sells USD to get Eurobonds, after he buys the Eurobonds, is he left with a short EUR position? So in the overlay strategy example above, he is managing/will be hedging the short EUR/long USD currency rates?
Remember, Bond Return in Domestic Currency = Bond Return in Foreign Currency + Return of Foreign Currency. If PM buys Eurobonds, he is implicitly long EUR through that investment, and a currency hedge overlay would go short EUR to offset the long Euro exposure. If you buy a Eurobond, you're hoping that the bond will perform well in local currency terms, and you're also hoping that EUR will strengthen vs USD. If right now a Euro costs $1.20, and at the end of your investment horizon, a Euro costs $1.30 (ie it has strengthened - become more expensive), you will be rewarded with an extra $0.10 for every Euro you invested once you convert your Euro investment back to USD (you're being rewarded for investing in an appreciating currency). I'm not the greatest with FX stuff, but I'm pretty sure that's right.
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