Handbook of Finance: Investment Management and Financial Management

Chapter 19. Currency Overlay

BERND SCHERER, PhD

Managing Director and Global Head of Quantitative Structured Products, Morgan Stanley Investment Management

Abstract: International diversification has always been an immediate and well understood recommendation for all domestic investors searching for less risky and more efficient (more return per unit of risk) asset portfolios. Practically, this advice is incomplete until we can also offer a unified framework how to manage currency risks. This contribution will distinguish between risk overlays designed to derive the strategic currency exposure and active overlays designed to take advantage from inefficiencies in the foreign exchange markets. As currency overlay management is one of the oldest portable alpha strategies and the grandfather of global tactical asset allocation, we will review some of the techniques used in the management of active overlays.

Keywords: currency overlay, regression hedging, unitary hedging, partial hedging, over hedging, cross-hedging, numeraire, forward rate bias, momentum strategy, regime-based weighting, stop loss

Currency risk has long been seen as the dark side of international diversification as investors realized that currency risk is always on top of asset risk. The one month return of a U.S.-based investor for buying German government bonds will be driven by movements in the German yield curve (interest rate risk) plus changes in the $/€ rate (currency risk). If left unmanaged, the diversification ...