Currency overlay management

Currency overlay refers to the specialised management of currency exposures inherent in an international asset portfolio, by a separate firm or entity from the asset manager.

Every investment in an international asset requires an equal investment in foreign currency. A currency overlay manager is dedicated exclusively to managing these 'accidental' currency exposures generated by the asset manager, separately from, but in parallel with, the underlying asset manager.

The underlying asset manager is not disturbed by the use of an overlay manager, and still manages currencies in the same manner as before. However, the overlay manager replaces the currency bets of the underlying manager with the deliberate investment position of the specialist overlay manager.

The resulting combination of managers facilitates the optimal combination - best currency decisions from the currency specialist, and best asset decisions from the asset manager. A currency overlay programme usually reduces pre-existing unmanaged currency risk, as it hedges pre-existing exposures.

How it works

Through the application of a portfolio of forward contracts, known as the overlay portfolio, the underlying currency exposure of the assets is altered to a deliberately intended portfolio of currency exposures. This separately managed currency exposure can be expected to have a higher return than the original set of exposures, generated accidentally by the asset manager.

In Practice

• Custodian sends currency exposure to overlay manager regularly.
• Overlay manager enters forward currency contracts in client's name.
• Custodian settles contracts upon instruction of overlay manager.
• Client provides any cash needed at settlement.