Currency overlay is a financial trading strategy or method conducted by specialist firms who manage the currency exposures of large clients, typically institutions such as pension funds, endowments and corporate entities. Typically the institution will have a pre-existing exposure to foreign currencies, and will be seeking to:
The currency overlay manager will conduct foreign-exchange hedging on their behalf, selectively placing and removing hedges to achieve the objectives of the client.
Many types of currency overlay accounts are more focused on the speculative aspect, i.e. profiting from currency movements. These so-called 'pure alpha mandates' are set up to allow the manager as much scope as possible to take speculative positions. As such, they are similar in nature to foreign-exchange hedge funds in terms of objective and trading style. Currency overlay is a relatively new area of finance; the first institutional overlay mandate was awarded only in 1983 when the UK water Authorities Superannuation Fund awarded a contract to Record Currency Management. [1]
Individuals and institutions who own equities, government bonds, cash, or other assets denominated in foreign currencies are exposed to fluctuations in the foreign exchange market. This is an unrewarded risk: the volatility in valuation of an international portfolio is generally increased by adding currency exposure, yet there is no risk premium earned for that added volatility in the long term. Thus investors with international portfolios often hedge their currency risk, normally using forward currency contracts, currency swaps, currency futures contracts, or currency options.
Currency hedging can be done passively or actively. The stream of returns from passive currency overlay is negatively correlated with international equities, has an expected return of zero, and does not employ any capital. The overlay manager uses forward contracts to match the portfolio’s currency exposures in such a way as to insure against exchange rate fluctuations. A decision list for a passive overlay manager would include [2]
The decisions will be informed by, among other things,
Active currency overlay requires management style decisions on the part of the manager, based on the types of model and model input that the manager chooses to employ. While these decisions are often real-time, some providers develop pre-defined rule based strategies. The most common categories in active currency overlay are as follows: [2]
Fundamental managers believe they can exploit price inefficiencies using models and processes in which economic and financial data are used as the ‘exogenous’ variables, including balance of payments, capital flows, price levels, monetary conditions, etc.
Technical managers tend to ignore completely external economic variables, and argue that price and price history provide the most effective mechanism for exploiting inefficiencies. A typical approach would be to model price history to determine successful trading rules.
Dynamic managers are a group that aims to create an asymmetric return—running profits and cutting losses—with forwards or option technology.
Option-based managers exploit systematic differences between implied and actual future volatility. [2]
The foreign exchange market exhibits systematic inefficiencies, owing mostly to its unique status among financial markets: only a small proportion of currency market participants are seeking profit in that market. Instead, most participants transact in the foreign exchange markets for other purposes—trade or investment, for instance.
Because the market is dominated by highly constrained participants like industrial and commercial companies, fund managers, portfolio investors, and central banks, there still exist arbitrage opportunities that are not fully exploited. These include cyclical behaviour, trending, disparities in implied and actual volatility, and the forward rate bias. [2]
In economics and finance, arbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalise on the difference, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the possibility to instantaneously buy something for a low price and sell it for a higher price.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.
Passive management is an investing strategy that tracks a market-weighted index or portfolio. Passive management is most common on the equity market, where index funds track a stock market index, but it is becoming more common in other investment types, including bonds, commodities and hedge funds.
In finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative.
A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.
A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps.
In finance, a swap is an agreement between two counterparties to exchange financial instruments, cashflows, or payments for a certain time. The instruments can be almost anything but most swaps involve cash based on a notional principal amount.
In finance, a foreign exchange option is a derivative financial instrument that gives the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. See Foreign exchange derivative.
Long/short equity is an investment strategy generally associated with hedge funds. It involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value. This is different from the risk reversal strategies where investors will simultaneously buy a call option and sell a put option to simulate being long in a stock.
Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financial loss and uncertainty about its extent.
Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.
The following outline is provided as an overview of and topical guide to finance:
In finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option. Options are typically acquired by purchase, as a form of compensation, or as part of a complex financial transaction. Thus, they are also a form of asset and have a valuation that may depend on a complex relationship between underlying asset price, time until expiration, market volatility, the risk-free rate of interest, and the strike price of the option. Options may be traded between private parties in over-the-counter (OTC) transactions, or they may be exchange-traded in live, public markets in the form of standardized contracts.
In finance, a stock market index future is a cash-settled futures contract on the value of a particular stock market index. The turnover for the global market in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for International Settlements at US$130 trillion.
A foreign exchange hedge is a method used by companies to eliminate or "hedge" their foreign exchange risk resulting from transactions in foreign currencies. This is done using either the cash flow hedge or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles as well as other national accounting standards.
Global Tactical Asset Allocation, or GTAA, is a top-down investment strategy that attempts to exploit short-term mis-pricings among a global set of assets. The strategy focuses on general movements in the market rather than on performance of individual securities.
A dual-currency note (DC) pays coupons in the investor's domestic currency with the notional in the issuer's domestic currency. A reverse dual-currency note (RDC) is a note which pays a foreign interest rate in the investor's domestic currency. A power reverse dual-currency note (PRDC) is a structured product where an investor is seeking a better return and a borrower a lower rate by taking advantage of the interest rate differential between two economies. The power component of the name denotes higher initial coupons and the fact that coupons rise as the foreign exchange rate depreciates. The power feature comes with a higher risk for the investor, which characterizes the product as leveraged carry trade. Cash flows may have a digital cap feature where the rate gets locked once it reaches a certain threshold. Other add-on features include barriers such as knockouts and cancel provision for the issuer. PRDCs are part of the wider Structured Notes Market.
A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rates of two currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk.
The S&P/ASX200 VIX (A-VIX) is a financial market product that participants trade based on the market price of the implied volatility in the underlying Australian equity index.
Record Currency Management (Record) is a British investment management company that specializes in currency management. It was a pioneer of currency overlay for pension and investment funds. The company is one of the largest independent currency managers in the world.