Currency Overlay

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.