Abstract
International diversification of investments exposes portfolios to exchange rate risk, which is a typical speculative risk. In this case, the overall performance of a portfolio is tied not only to the returns of individual investments, but also to variations over time of the exchange rates of the different currencies against the so-called home currency, taken as the base currency by the investor. As exchange rates are subject to specific factors that are distinct from those of traditional financial assets, currencies can be seen as an autonomous alternative asset class. In its passive version, currency overlay seeks to manage currency risk, in order to limit its potentially negative impact on investments denominated in foreign currencies. In contrast, active currency overlay combines the management both of risk and of the currency asset class, with the aim of increasing overall portfolio performance. The features of passive and active currency overlay techniques are object of examination in this chapter, also with recourse to practical examples.
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Notes
- 1.
Pojarliev and Levich (2014).
- 2.
For example, there are companies specialised in currency overlay that offer their services to managers of financial assets (Xin 2011).
- 3.
The values at times t or T are given in upper case, while their percentage changes from t to T are given in lower case. In line with the literature on currency overlay, but not with operational practice, here exchange rates are calculated according to the direct or price quotation, i.e. indicating the amount of base currency required to purchase a unit of the quoted currency.
- 4.
Below, in agreement with Ankrim and Hensel (1994) and the main literature, we refer to forward premium, irrespective of whether its value is positive or negative.
- 5.
Note that, irrespective of the convention used for the exchange rate, in the calculation of the forward premium the numerator must be the interest rate of the quoted currency and the denominator that of the base currency. In this case indirect quotation is used, and therefore the home currency is the variable quantity in the exchange rate.
- 6.
Note, in particular, the study by Burnside et al. (2011).
- 7.
- 8.
Wystup (2006).
- 9.
Schmittmann (2010) notes that in 2004 only 13 % of US institutional investors used hedge ratios other that 100 % or 50 % of the expected value of the portfolio.
- 10.
Conventionally, financial markets use indirect or quantity quotation for the euro exchange rate, which gives the amount of foreign currency needed to purchase a unit of home currency. For this reason, it is indicated here by the symbol 1/S (see also note 2). Moreover, for the sake of simplicity, the bid-ask spread is not considered. The rates given here must be interpreted as mid-spread and assumed to be identical both for the buyer and the seller of the currency.
- 11.
Eun and Resnick (1988).
- 12.
It is important to note that a forward contract does not require payment of an initial margin. It is sufficient to have a line of credit in foreign currency. Alternatively, for the main non-convertible currencies (i.e. currencies of those nations that impose restrictions on the movement of capital), a non-deliverable forward can be contracted, which does not require physical delivery of the future sum, but a net cash settlement.
- 13.
Note that the currency surprise is zero only in the case of full hedging.
- 14.
James et al. (2012).
- 15.
For the sake of completeness, we should also consider the correlations between the portfolio of financial assets and the spot and forward exchange rates. On the other hand, the difference between the volatility of these two types of exchange rates is so marked as to make almost negligible the impact of any greater correlation between the portfolio and the forward rates compared to the spot rates. Indeed, Schmittmann (2010) calculates the volatility of f as between 7 % and 16 % of the volatility of s.
- 16.
The first article to propose the ‘free lunch’ theory—albeit uncommon in the financial field—was Perold and Schulman (1988). The theory has been re-stated in various forms by numerous academic studies in the course of the subsequent two decades. For a review of the literature and an empirical assessment (with a negative outcome), see De Roon et al. (2012).
- 17.
Therefore, in the so-called developed markets, the MSCI EAFE index excludes only the United States and Canada.
- 18.
Vectors and matrices are indicated in bold type. In this case, each vector is composed of a time series of returns in periods prior to t, with an identical length of \( T-t \).
- 19.
A European put option grants the holder the right to sell a specific currency at a given future date in exchange for a sum expressed in another currency calculated on the basis of a specified exchange rate. European currency options are priced using a modified version of the Black-Scholes formula called Garman-Kohlhagen, which uses two risk-free rates, one for each currency.
- 20.
Celebuski et al. (1990).
- 21.
The topic of currency options is broad and complex. For details of applied aspects and an exhaustive empirical analysis, see: James et al. (2015).
- 22.
Record (2003).
- 23.
Note that investors make decisions based on a single-period horizon, so the returns path in the home currency between t and T is not relevant. If instead this discrete-time model is replaced by a continuous-time one, a constant rebalancing of the hedge ratio should be assumed. This assumption is theoretically acceptable, but impossible in operational reality.
- 24.
James (2004).
- 25.
Huttman and Harris (2006).
- 26.
James et al. (2012). The only exception is the possible use of currency options.
- 27.
- 28.
Menkhoff et al. (2012a).
- 29.
Asness et al. (2013).
- 30.
Menkhoff et al. (2012b).
- 31.
Engel (1996).
- 32.
Note that as the yen is the quoted currency in the exchange rate, the interest rate on deposits denominated in yen is the numerator in the formula to calculate the forward premium (indicated as f).
- 33.
Hauner et al. (2011).
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Abate, G. (2016). Currency Overlay. In: Basile, I., Ferrari, P. (eds) Asset Management and Institutional Investors. Springer, Cham. https://doi.org/10.1007/978-3-319-32796-9_16
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