Overview

A currency overlay is a portfolio management strategy usually conducted by firms that specialize in managing the currency exposures of institutional portfolios. Typically the portfolio will have a pre-existing exposure to foreign currencies, via investment in equity, debt, or other securities. The firm is seeking to either:

• Limit the risk from adverse movements in exchange-rates (i.e. hedge), or
• Profit from tactical foreign exchange views (i.e. speculate)

The currency overlay manager will conduct foreign exchange hedging on the client’s behalf, selectively placing and removing hedges to achieve the objectives. 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.

Take an example without overlay. The fund is a USD-base fund holding EUR base stocks. The manager wants to hedge against adverse movements in the USD/EUR exchange rate. She will sell EUR for USD forward. Here, the stocks and the forward contract will be present in the same portfolio. The currency gain/loss on the underlying assets will move in an opposite direction of the hedges.

Overlay works the same way, except the forwards will be in a different portfolio, controlled by a different manager or firm. Options, futures, and swaps can also be used to adjust currency exposures.

Performance

Single-Period (Daily, Monthly) Return: the methodology (formulas) for calculating a currency overlay portfolio return is the same for any other account. That is, you can use the daily return, Modified Dietz return, etc. However, there is a major consideration for calculating currency overlay portfolio returns, the return denominator when the hedges are in a different portfolio.

Numerator: to calculate a single-period return, we need the gain/loss (numerator) and the beginning or average capital invested (denominator). For an overlay portfolio, the numerator will be the mark-to-market (unrealized gain/loss) of the hedges and other instruments in the overlay portfolio.

Denominator: the denominator for the currency overlay return needs to be calculated with reference to the underlying portfolio. A notional denominator is used. It is typically the value of the underlying portfolio, at the beginning of the day or month. Best practice is to calculate and load a notional cash flow for this value each day or month to the currency overlay account. The reason for this is to enhance the transparency of the return calculation.

Loading Notional Denominator: the notional denominator will either need to be maintained on the accounting system or directly in Eagle Performance. The optimal method depends on several factors, including whether the overlay portfolio is managed in or outside of the firm, management style, and client mandates. Each calculation may vary in the assumption of how both the underlying and physical assets grow over time. It is not uncommon for a firm to require several different methods of sourcing a notional denominator. Here are two methods that have been used:

1. The overlay amount is represented in the accounting system as a dummy asset. In some accounts it is a constant market value, while in other accounts the asset's market value is adjusted daily to match the custodian's.  Download this market value each day to PACE. This method can also be used to load the value from a spreadsheet.
2. The assets being overlayed are assumed to grow with the benchmark. Some do this by applying a daily benchmark rate to the underlying assets, while others assume that the adjustment compounds over the course of the month. Use a return calculation report to calculate the new value each day as yesterday’s value * (1 + benchmark return).  Retrieve this value into the calculation report for the overlay portfolio.  At month-end, reset the value based on the actual value of the account.