Active Currency Overlay
Active overlay strategies aim to minimise exchange rate and liquidity risks while still enabling investors to participate in positive exchange rate movements. To this end, the overlay manager utilizes currency forwards to dynamically adjust the hedge ratio in response to changes in exchange rates. Hedging positions are increased when exchange rate movements are unfavourable and vice versa.
Decisions to alter the hedge ratio are made systematically using a quantitative approach based on a multi-model architecture. The models used differ in terms of maturity (short, medium, long) and characteristics (trend-following, oscillating, fundamental). This approach avoids discretionary decisions and reduces the reliance on key personnel. The trading system comprises a disciplined and understandable set of rules defined in advance by the overlay manager in consultation with the client.
The big advantage of an active currency overlay is its flexibility. It responds to both short to long-term exchange rate trends and sudden changes in market conditions. Investors can take advantage of positive exchange rate movements by reducing the hedge ratio accordingly. If the overlay system indicates that the risk rises again, the hedge ratio is stepped back up to realize interim gains and protect the investor against expected losses. In this way, active overlay strategies effectively reduce currency risk. At the same time, the opportunity costs are lower than in a passive strategy. The dynamic management of the hedge ratio thereby replicates the risk profile of an option with one key benefit: it avoids payment of the option premium.
The efficiency of an active FX overlay results from a reduction in hedging expenses in the form of forward premia that the investor would have to pay in full if the entire exposure were hedged in the forward market. The capital tied up in the hedge is usually lower than in a passive strategy. That is particularly relevant for high-interest currencies, such as the South African rand, where passive hedging can be prohibitively expensive.
Active overlay is mainly aimed at clients who want to hedge long-term currency risks. For companies, these may be translation risks for foreign investments, whereas for institutional investors they comprise portfolios of securities denominated in foreign currencies.