Passive Currency Overlay
In a passive currency hedging strategy the overlay manager sets a constant hedge ratio that is not altered during the hedging period ("static hedging"). The hedge ratio is determined by the investor's risk tolerance and a target parameter that the investor wants to meet, for example EBIT or the target annual return of an investment fund.
Passive management via currency forwards effectively reduces the risks relating to exchange rate movements. However, depending on the hedge ratio selected, it does not allow participation in exchange rate trends that would benefit the investor. Moreover, compared with a dynamic approach, the investor must normally hold higher capital reserves available to meet potential payment obligations arising from forward transactions. That said, the overlay manager ensures a reliable planning base for clients through stringent monitoring of the cash flows expected to be generated by the forward contracts and timely action if there is any threat of limit violation.
In addition, FX Risk Management optimises passive currency hedges thanks to permanent monitoring of hedging costs. Costs can be reduced considerably by effective selection of the hedge ratio and analysis of yield curves and bid-offer spreads.
Passive hedging is especially advisable for clients with investment restrictions specifying a fixed hedge ratio. In addition, passive strategies are chosen by clients interested in short-term hedging of risks relating to foreign transactions or payments in foreign currencies. For example, companies may wish to hedge foreign sales.
By contrast, companies with long-term translation risks and investors with medium to long-term currency exposures, for example, from a globally diversified equity or bond portfolio, often opt for active hedging. After all, a static approach may be unsuitable in light of dynamic market conditions with temporary price trends and phases of increased exchange rate volatility, which passive hedges cannot easily react to.