Currency Overlay: What It Is, How It Works

Currency overlay is a strategy international investors and fund managers use to farm out currency risk management to a specialist firm or an overlay manager. Used in global investment portfolios, typically by institutional investors, this separates the management of currency risks from decisions over asset allocation and selection. The currency overlay strategy aims to reduce the currency-specific risks of investing in international equities.

Understanding Currency Overlay

The strategy of currency overlay is designed to mitigate the financial impact on an investment portfolio from exchange rate fluctuations or when investing in international assets valued in a foreign currency. Each day, trillions of dollars exchange hands in the global currency market, making it the largest worldwide.

Corporations, central banks, major banks, investment firms, brokers, and institutional investors buy and sell assets in foreign currencies. Global trade, international loans, and investments involve exchanging one currency for another at the prevailing exchange rate.

Many investment firms offer currency overlay services designed to reduce or eliminate exchange rate conversion losses when investing internationally. The currency hedging is then “overlaid” on the portfolios created by other money managers. 

Why Currency Overlay Is Necessary

Currency risk management is essential for most portfolios with direct international holdings. Suppose 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. In that case, the profit or loss of the Japanese holdings is unaffected by currency fluctuations. This, however, would be rare, as currencies fluctuate against each other all the time.

Exchange Risk

Foreign investments typically involve an exchange of local currency for that of the country where the funds are being transferred. When the funds are brought back to the home country and converted, another exchange occurs at the prevailing rate of the time.

The difference between the rates for the two currency exchanges (out and then back into the home currency) can result in a gain or a loss. As a result, investments can increase or decrease in value based just on the exchange rate conversions alone—all else being equal.

For example, if an American wires $100,000 to Europe to be invested, and the exchange rate is $1.05 for each euro, it would equal about 95,238 euros. Let's say the investor earned a 5% return on the investment and wired the money back to the U.S. In the meantime, the exchange rate fell to $1.00 for each euro, a 4.8% decline in the rate (from $1.05). This would wipe away almost all of the gain from the investment.

Event Risk

Exchange rate changes are caused by many factors, including shifts in economic conditions when an economy grows or contracts. When countries encounter slower growth or a financial crisis, this can result in investors taking capital out of the country to put into more stable economies.

As a result, the public release of economic indicators such as consumer spending, unemployment, and gross domestic product affect exchange rates. Other political developments, as well as natural disasters, can also lead to these changes.

Central Banks

Those who conduct currency overlay hedges pay close attention to central banks worldwide, such as the Federal Reserve Bank (Fed). As part of the Fed's efforts to manage U.S. monetary policy, it adjusts its short-term interest rates. A country with higher rates tends to attract more investment capital—all else being equal. If a country's central bank lowers its rates, that typically indicates economic challenges, which can lead to a flight of capital to other countries.

Investors usually hedge their portfolios against currency risks such as these—that or hope to be prescient about upcoming currency swings and reposition their holdings accordingly. Currency overlay hedges use financial products to help mitigate these events' impact on an investment portfolio. In practice, this is usually done through contracts or complementary forex trading.

With large holdings spanning the world, hedging the portfolio can be as time-consuming as picking assets in which to invest. This is the reason specialist firms offer currency overlay. Institutional investors can focus on investing, and the currency overlay firm manages the currency. 

Passive vs. Active Currency Overlay 

A currency overlay strategy can be passive or active. The passive currency overlay is a hedge over the foreign holdings to shift the currency exposure back into the fund's domestic currency without any loss because of exchange rate changes. This process locks in an exchange rate for the contract period, and a new contract is put into force when the older one expires. The product typically used is called a forward contract, which deals with the currency risk without trying to 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 convert funds into euros for investment purposes 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. As such, this passive strategy involves no attempt to speculate or profit from potential changes in the exchange rate.

By contrast, an active currency overlay involves hedging that limits currency exposure while seeking positive returns from favorable currency swings. An active currency overlay will try to capture the excess return from the exchange of funds rather than simply converting without loss back to the base currency. To achieve these excess returns, a part of the total portfolio is left unhedged, with the overlay manager making decisions on currency positioning to create chances for profit. 

The Bottom Line

Currency overlay is a risk management strategy normally done by specialist firms. When investing internationally, investors frequently must convert their capital into other currencies. Over time, the values of the home and foreign currencies might fluctuate considerably, leaving you with a vastly different result than expected when it’s time to sell and convert the proceeds back to your original medium of exchange.

You may be a great investor. However, your success can be erased if you don’t think about the currency impact. Currency is a key part of international investing, and currency overlay can help ensure that your currency exchanges either go in your favor or at least don’t destroy potential returns.