Currency Overlay: A Practical Guide

Posted by Allison on 13 April 2009, 10:57

The practice of currency overlay is generally practiced by extremely large banks and corporations, but understanding what it is and why it is important are good things for all foreign currency exchange market traders to understand.  Currency Overlay:  A Practical Guide is a very good book for this purpose, offering clear and concise explanations to help the reader truly comprehend the practice of currency overlay.     

What is currency overlay and why is it important?

The practice of currency overlay is important to large banks and corporations because it allows them to better manage the currency risk that is in their existing portfolios.  How?  By turning over the management of currency risk to an outside provider rather than continuing to manage it within the organisation itself.   Currency Overlay:  A Practical Guide emphasises that the practice of currency overlay is reserved for existing currency risk in an existing international portfolio, not for taking on new currency risk and then managing it. 

As explained in Currency Overlay:  A Practical Guide, a corporation or bank with currency risk exposure has three options for how to handle the risk:

  • Leave it alone and take no action – This is an extremely risky option, creating a great deal of volatility in an international portfolio and leading to irregular rates of return.  The potential for losing money is very high with this option.
  • Create a hedge that is passive – This is an extremely simple option to create and execute, but it significantly reduces the level of diversification in an international portfolio.  The potential for losing money is relatively low, but the reduction in diversification is typically not a preferred situation.
  • Adopt the practice of currency overlay – This is the primary option used by large banks and corporations in the modern global financial marketplace.  It offers the benefit of reducing risk due to currency exposure in the international portfolio while taking advantage of opportunities for generating high rates of return.

Currency Overlay:  A Practical Guide covers all of this in excellent detail, explaining that currency overlay is one of the most popular methods chosen by large institutions.

Two approaches to currency overlay management

There are two primary approaches to currency overlay management:

  • The hedging approach
  • The speculative approach

The approach used by the currency overlay management firm depends on the needs and requirements of the institution that has hired their services.  Some clients, such as some pension funds and retirement agencies, are typically interested in the hedging approach as a way to reduce risk and ensure the continued stability and growth of their portfolio.  Other clients, such as some corporations and large banks, prefer the speculative approach because it allows them to more aggressively go after larger, more profitable returns.

Currency Overlay:  A Practical Guide contains excellent discussions of these approaches, including specific detail that really makes them become clear.  Even with this level of detail, however, the book does not lose any of its readability at all.

Comprehensive collection of currency overlay topics

One the reasons why Currency Overlay:  A Practical Guide is such an excellent resource is the comprehensive collection of topics it includes, providing very clear and thorough explanations of all aspects related to currency overlay.

Let's take a look at just a few of these topics:

  • Introduction to currency markets – The book begins with a concise look at modern currencies, including the history of the foreign exchange market and some critical facts about currency trading.  This information leads directly into an initial explanation of currency overlay and the need for managing currency risk.
  • Understanding the nature of currency risk – The book provides an excellent discussion of currency risk, including how it is defined, ways it can appear in an international investment portfolio, and the concepts of risk responsibility versus risk separation.
  • The basics of currency overlay management – The book contains a very thorough discussion of the basics of currency overlay management, establishing a solid foundation of knowledge before moving on to more detailed discussions.  The content includes how currency overlay was developed, how it is defined, the process of currency overlay, understanding opportunities and trends, the actions and responsibilities of currency managers, different styles of trading, and other issues related to outsourcing the currency management function.
  • Choosing a management style – The book covers several factors that influence the currency management style preferred by the large bank or corporation, including models based on purchasing power parity, macro model, quantitative models, technical analysis, and more.
  • Specifics of currency overlay management – The book takes on a wide array of topics related to currency overlay management, providing very specific explanations that are both straightforward and easy to understand.  Some examples of the specifics covered include hedge ratios, optimization, performance measurement, benchmark design, emerging market currencies, dynamic hedging, theories of option pricing, liquidity, and the effects of e-commerce and the online environment.

How do currency managers reduce risk and still generate profits?

This is a common question related to currency overlay practices, and one that Currency Overlay:  A Practical Guide discusses quite thoroughly.  The discussion centres on why the opportunities exist and which currency market participants typically influence the quantity and scope of these opportunities:

  • General currency exchange – These are the travellers and tourists who need to exchange currency at a specific time, regardless of the current exchange rates.  Their presence in the currency market is generally at its highest during peak travel and vacation times.
  • Fund managers – These are the professional money managers, usually for fixed income funds and index equity funds, who also do not have the luxury of waiting to trade currency when the profit potential is highest.  As fund managers, they have to sell/buy currency based on the changing set of index change constituents.
  • Major central banks – These are the extremely large banks whose purpose is to represent and serve the currency needs of their specific country.  In this role, they often get involved in the currency exchange market with the intention of affecting the strength (or weakness) of their country's currency, or to control the rate of inflation.  When they make these moves, opportunity is created for other market participants.
  • Large corporations – The treasurers of large corporations periodically must enter the foreign currency exchange markets as part of their corporate responsibilities.  Specific situation where they might do this include when they have receivables that need to be hedged or when they need to repatriate significant profits.

All of these participants create opportunities for currency overlay managers to achieve profitable trades while still maintaining a reasonable level of currency risk management.

Final thoughts

While currency overlay is not a topic or practice individual investors need to concern themselves with directly, all traders should have a good understanding of what it is and how it works because it can influence their trading activities indirectly.  There are many books available on this subject, but few are as accessible and as easy to understand as Currency Overlay:  A Practical Guide.

This book is full of information and explanations that make the concept of currency overlay very clear, but without getting too deeply into the nuances and complexities of it.  There are numerous graphs and illustrations to go along with each topic, making it particularly easy to visualize the concepts discussed.  The author does an excellent job of presenting a combination of specific details along with supporting visuals, helping the reader understand the concept being presented more quickly.

In general, Currency Overlay:  A Practical Guide is the kind of book every foreign currency exchange market trader should consider adding to their resource library.  While it is not a book that will be used every day or on a regular basis, it is something that provides additional information about the currency markets that is well worth reading about and understanding.

Direct link to this book at Amazon

 

Comment

  1. I must admit this whole currency overlay thing really went over my head. I read the whole article and I’m not much the wiser. I’ll have to read it again I think. Although having said that the book seems like a good bet if anyone wants to find out more about it. It doesn’t seem to be something that impinges on many people’s consciousness – I have certainly never heard of it before and I bet I’m not alone in saying that.

    — Jen · Mar 30, 09:08 AM · #