Currency overlay is an investment strategy employed by institutional investors to protect their portfolios from currency fluctuations.
The currency overlay manager first identifies the currency risk exposure of the portfolio, and then enters into currency hedging transactions to offset that risk.
Currency overlay can be used to hedge both:
- currency risk arising from investments denominated in foreign currencies, and
- the currency risk of domestic investments that are exposed to foreign currency movements through imports, exports, offshore business, and so on
While currency overlay is most commonly used by large institutional investors, it can also be employed by individual investors looking to protect themselves from currency volatility.
Currency-hedged mutual funds and exchange-traded funds (ETFs) offer a way for individual investors to get exposure to foreign markets without having to worry about the potentially adverse effects of currency fluctuations.
To hedge this currency risk, investors can enter into currency hedging transactions.
There are a number of different currency hedging strategies that currency overlay managers can use to offset currency risk exposure.
Currency forward contracts
The most common currency hedging strategy is to enter into forward contracts.
A forward contract is an agreement to buy or sell a currency at a future date at a predetermined exchange rate.
By entering into a forward contract, the currency overlay manager is able to lock in an exchange rate for a future transaction, and protect the portfolio from adverse movements in the currency market.
For example, a currency overlay manager with a portfolio of US dollar-denominated assets can enter into a currency forward contract to sell euros at a future date.
If the value of the euro falls against the dollar, the currency forward contract will offset the loss in value of the portfolio’s euro-denominated assets.
Currency-hedged mutual funds and ETFs
Investors who want exposure to foreign markets but want to avoid the currency risk can invest in currency-hedged mutual funds and exchange-traded funds.
These types of funds hold a portfolio of securities and use currency hedging techniques to offset the currency risk.
Currency-hedged mutual funds and ETFs give investors the opportunity to participate in the potential upside of foreign markets without having to worry about the downside risk of currency fluctuations.
Investors should be aware that currency hedging comes with its own set of risks, including basis risk and rollover risk.
Basis risk is the risk that the currency hedge will not perfectly offset the underlying currency exposure.
Rollover risk is the risk that positions held in forward contracts will have to be closed out at a loss if the currency moves in an unfavorable direction.
A currency swap is an agreement between two parties to exchange currency denominated in one currency for another currency.
Currency swaps are often used by currency overlay managers as a way to hedge currency risk.
For example, a currency overlay manager with a portfolio of US dollar-denominated assets can enter into a currency swap with a counterparty and exchange their US dollars for Japanese yen.
This would protect the portfolio from a decline in the value of the US dollar against the Japanese yen, wherever that exposure exists.
Currency swaps can be used to hedge against currency risk exposure in both foreign investments and domestic investments that are exposed to foreign currency movements.
Currency options are another tool that currency overlay managers can use to hedge currency risk.
A currency option gives the holder the right, but not the obligation, to buy or sell a currency at a specified exchange rate on or before a certain date.
Currency options can be used to hedge against both foreign currency risk and domestic currency risk.
For example, a currency overlay manager with a portfolio of US dollar-denominated assets can purchase put options on the Japanese yen.
This would give the manager the right to sell Japanese yen for US dollars at a specified exchange rate on or before a certain date.
If the value of the Japanese yen declines against the US dollar, the currency overlay manager can exercise their option and sell Japanese yen for US dollars at a profit.
Currency futures contracts
Currency futures contracts also serve the same purpose and are similar to currency forwards.
A currency future is a contract to buy or sell a currency at a specified exchange rate on a certain date in the future.
Currency futures contracts are traded on exchanges and are used by currency overlay managers as a way of hedging currency risk.
For example, a currency overlay manager with a portfolio of US dollar-denominated assets can enter into a currency future contract to sell Japanese yen if there was the desire to hedge out any equivalent amount of yen exposure.
This would give the manager the right to sell Japanese yen for US dollars at a specified exchange rate on a certain date in the future.
If the value of the Japanese yen declines against the U.S. dollar, the currency overlay manager can exercise their contract and sell Japanese yen for US dollars at a profit equivalent to the favorable movement in the futures contract.
Currency forwards vs. futures
Like currency forward contracts, currency futures can be used to hedge currency risk exposure.
However, there are some key differences between currency forwards and futures.
One difference is that currency futures are traded on regulated exchanges, while currency forwards are not.
This means that currency futures are subject to exchange fees, while currency forwards are not.
Another key difference is that currency futures contracts are standardized, while currency forward contracts are not.
This means that currency futures contracts can be easily traded and exchanged, while currency forward contracts cannot.
Finally, currency futures contracts have expiry dates – they have to be rolled – while currency forward contracts do not.
This means that currency futures contracts must be settled on or before their expiry date, while currency forward contracts can be held until maturity.
Currency overlay as a means of diversification
Currency overlay can also be used to better diversify one’s currency exposures.
Most portfolios are heavily biased to be long a certain asset class, all denominated in the same currency.
Capital isn’t so much destroyed in markets (i.e., when asset classes fall), but shifts to other things.
It’s always shifting between different assets, asset classes, countries, currencies, and financial and non-financial stores of value.
This makes the case for not having a portfolio entirely in a single currency as a means of prudent diversification.
Currency overlay using gold
Currency overlay managers can also use gold to hedge currency risk.
Gold is traditionally seen as a safe haven asset and is used by investors to protect against currency risk.
For example, gold can be used to hedge currency risk in a portfolio of assets denominated in any currency.
If the value of a currency falls (e.g., against other currencies, lower real yields), the value of gold will typically increase simply because its price is a reflection of the value of the money used to buy it.
Gold is something that is not anybody else’s liability, unlike financial wealth where someone has to make due on the claim.
A strong domestic currency might mean a falling gold price simply because the value of money is rising relative to alternative stores of value.
Many portfolio managers use gold as a currency overlay in an allocation of somewhere around 5 to 15 percent.
And without taking away from other assets in the portfolio (e.g., not selling equities or other assets just to buy gold, but perhaps simply buying gold through the futures market or another method).
Other currencies can be used similarly
A US-based trader or investor will have their portfolio in dollars.
Currency overlay can be accomplished with other currencies, such as buying foreign assets denominated in other currencies, diversified commodities baskets, or simply having spot FX exposure.
These would not serve as core portfolio positions (i.e., exposures to them would be small), but to help diversify currency exposure in a portfolio.
Currency forwards, currency swaps, currency options, and currency-hedged mutual funds and ETFs are all tools that investors can use to offset currency risk exposure.
Currency overlay is one tool that currency traders can use to manage currency risk.
It may involve strategies that use a mix of currencies to offset the risks posed by any one currency.
Currency overlay can be used to protect against currency risk, or it can be used to take advantage of expected changes in currency values.
Gold is often used as a currency overlay because it is seen as a safe haven asset.
Other currencies can also be used as currency overlays.
Each currency overlay strategy has its own advantages and disadvantages, and each should be used in a way that is appropriate for the trader or investor’s individual circumstances.