Currency overlay programs are committed to the management of current currency risk in a portfolio; currency exposures are looked upon as a distinct choice from the comprehensive asset distribution. The goal of currency overlay programs is to restrict losses and optimize gains that occur from currency risk.
In the context of the volatility of exchange rates, it is expected that investments in global equities are unpredictable. Currency risk can have an adverse effect on a portfolio that contains foreign denominated stock.
Investment in foreign denominated currency results in additional risk to portfolios. However, currency overlay programs can reduce the risks, while some result in profit opportunities.
The overlay programs are committed to the management of current currency risk in a portfolio. However, a currency overlay program is not a direct investment. It is a risk management program executed with derivatives that do not need an asset distribution.
Currency overlay can be passive/active. A passive overlay is not very complex. A comprehensive hedge of the currency exposure is established and efficiently transforms the complete foreign exchange exposure into the base currency. The emphasis of such a strategy is to remove the risk. This method does not look at supplementing additional return to the portfolio. By flattening out the peaks and valleys in asset values because of currency changes, a passive currency hedge removes all the risk due to exposure to foreign currency. It delivers improved stability to asset values.
A passive currency overlay is implemented utilizing basic derivatives, especially futures, forwards, and swaps. The advantages of passive currency management occur from the total effortlessness of the strategy.
A portfolio is safeguarded from any unfavorable fluctuations in foreign currency. This would enable the investor to assume more risk in other asset classes. The fees are also less since the strategy has been passive and depends on standardized derivative contracts. Though passive overlay programs are correct for certain clients, they are very basic in nature and structure.
Active overlay programs seek to decrease losses from foreign currency exposure. For a normal currency overlay execution, an initial hedge ratio is established. The initial hedge ratio is identified on a portfolio specific basis by looking at factors like clients’ assets, liabilities and liquidity requirements. The part of the portfolio that is not hedged is then actively managed to create alpha by manipulating currency fluctuations.
Currency overlay programs could be of use to investors who are concerned about the currency risk that is a part of international investments. Passive and active programs are available to meet the objectives and risk tolerance of every specific plan. Before pursuing an overlay program, investors must prudently assess their overall asset allocation, future liquidity requirements, and investment policy guidelines to determine if an overlay program is appropriate.