Currency Overlay

A method of outsourcing currency risk management to an overlay manager.

Author: Elliot Meade
Elliot Meade
Elliot Meade
Private Equity | Investment Banking

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in Piper Jaffray's Leveraged Finance group, working across all industry verticals on LBOs, acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at Citi in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

Reviewed By: Osman Ahmed
Osman Ahmed
Osman Ahmed
Investment Banking | Private Equity

Osman started his career as an investment banking analyst at Thomas Weisel Partners where he spent just over two years before moving into a growth equity investing role at Scale Venture Partners, focused on technology. He's currently a VP at KCK Group, the private equity arm of a middle eastern family office. Osman has a generalist industry focus on lower middle market growth equity and buyout transactions.

Osman holds a Bachelor of Science in Computer Science from the University of Southern California and a Master of Business Administration with concentrations in Finance, Entrepreneurship, and Economics from the University of Chicago Booth School of Business.

Last Updated:December 27, 2023

What Is a Currency Overlay?

Currency Overlay is a method of outsourcing currency risk management to an overlay manager. By doing this, managing currency risk is no longer the money manager's responsibility. The money manager can instead focus on security selection and asset allocation.  

The goal is to reduce the currency-specific risks of investing in international equities. Due to fluctuations in the exchange rate between two currencies, an investor may see the profits made from an international investment diminish.

This will happen when the home currency depreciates against the foreign currency more than the investment appreciates.

During the process, overlay managers may pursue a passive or active overlay method. The manager will secure a desirable exchange rate through forward contracts in a passive overlay. 

State Street Global Markets is the global leader in currency overlay management, with $335 billion in hedged assets under management as of the end of 2021. 

Understanding A Currency Overlay

Investors from various disciplines, including individuals, institutions, and banks, can hold international assets. These assets are often denominated in foreign currencies.

As a result, fluctuations in the exchange rate can seriously impact the value of these investments. 

The global currency market is the biggest in the world. It is worth over $2.409 quadrillion, with $6.6 trillion traded daily on foreign exchange markets. So, when anyone buys or sells assets in a foreign currency, they contribute to the global foreign exchange market.  

Currency overlay aims to reduce the financial impacts of currency fluctuations on portfolios. This happens through hedging using:

  • Currency forward contracts
  • Foreign exchange trading,
  • Futures.

A currency forward contract is an agreement between a buyer and a seller in the foreign exchange market. This is used to lock in a fixed purchase price of a currency at a specified date. 

Overlay managers use this to manage exposure to the risk caused by currency fluctuations. 

These contracts do not require any upfront payments, making them more desirable than a futures contract. However, as forward contracts are often valued at $1 million or more, they are not usually used by small firms or individuals.

In the active overlay, the manager will leave a portion of the portfolio unhedged. This portion will then be used to make a profit using futures, foreign exchange, or options contracts.

Firms have been offering the use of currency overlay since the mid-1980s. Since then, the demand for its services has grown tremendously. 

This is because as the world has become more globally integrated, the amount of assets held in foreign currencies has increased. Therefore the demand for currency risk protection has also increased.

Why is a Currency Overlay needed?

A currency overlay is necessary to ensure that foreign investments are protected against fluctuations in the exchange rate. 

When an investor decides to invest in a foreign asset, a currency conversion occurs, converting from domestic to foreign currency. When the investor transfers their money from a foreign-held asset to their domestic currency, another currency conversion occurs.

During the time between the initial investment being made and the investor withdrawing their money and converting it back into their domestic currency, the exchange rate is likely to have changed. 

If the domestic currency depreciates, the investor risks losing money. Currency overlay is used to minimize this risk through a process of hedging.  

Example Of Currency Overlay

An investor in the United States owns foreign stock. This is denominated in local currency and has appreciated by 7%. Therefore, the investor should be happy if there are no currency fluctuations. 

If the exchange rate between the US dollar and the foreign currency has declined 9% against the US dollar, then the 7% profit will be a 2% loss.

Once the stock is sold and converted back into dollars, all profits are lost. Therefore, we can see why having no currency risk management can determine the outcome of a trade and why currency overlay is necessary to protect profits against currency fluctuations.

The Role of Central Banks in Currency Overlay

Central banks are in charge of setting the monetary policy within a country by increasing or lowering interest rates. In the US, the central bank is known as the Federal Reserve.

Overlay managers will often pay close attention to central banks' behavior. They do this in their home country and any foreign countries they hold currency in. This is because the central banks' decisions about their monetary policy will likely affect the exchange rate. 

The primary role of a central bank within a country is to manage inflation to achieve price stability. This is done by lowering or increasing interest rates. 

When a country has higher interest rates, ceteris paribus, this will likely cause an increase in foreign investment. This indicates financial or economic growth, meaning that the interest earned will be greater, further increasing foreign investment. 

For this to occur, these investors will have to buy the local currency, meaning that demand for the home currency and the value will increase. From this, we can see how a central bank can affect the exchange rate of its home currency against another foreign currency.

Passive Overlay vs. Active Overlay

A currency overlay can be passive or active, depending on the investor’s needs. A passive overlay will involve the entire portfolio being hedged and will be the safest choice to ensure that profits are protected. 

An active overlay means that a portion of the portfolio is left unhedged to allow for the possibility of profiting from swings in exchange rates.

Passive Overlay

The entire portfolio is hedged against currency fluctuations if a currency overlay is passive. This is done using a forward contract to secure the foreign currency at a desirable exchange rate.

By doing this, the overlay manager will not need to worry about fluctuations in the foreign currency as the money is now essentially in the home currency. 

Active Overlay

Unlike a passive overlay method, investors can choose to have their overlay manager take an active overlay approach. 

This is where the overlay manager will leave a portion of the portfolio unhedged. This is to create profits from currency swings to increase returns to the investor.

The overlay manager will “actively” manage the portion of the portfolio that is left unhedged. They may do this through various methods, using futures, foreign exchange, or options trading. 

The weighting of the left unhedged portfolio will be tailored to the investor's needs. For example, if they wanted a riskier, more aggressive strategy, the investor may instruct the overlay manager to leave a larger portion of the portfolio unhedged. 

This means that more of the portfolio can profit from currency fluctuations, but it is also at greater risk of a loss.

We can summarize with the following table: 

Passive Vs. Active Overlay
Context Active Overlay Passive Overlay
Risk High Low
Return It can be greater than the initial return but can also be smaller than it. Likely to be similar to the return on the investment.
Workload The overlay manager will have to actively monitor and adjust the portfolio accordingly, requiring a lot of work.  

Currency Overlay FAQs

Researched and authored by Seb Bailey | LinkedIn 

Reviewed & Edited by Ankit Sinha LinkedIn

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