Currency overlay

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:
limit the risk from adverse movements in exchange rates, i. e. hedge; and
attempt to profit from tactical foreign exchange views, i. e. speculate. 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.

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.

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.