Currency Hedging with a Derivatives Overlay

This chapter demonstrates how institutional investors use derivatives to manage FX risk in globally diversified portfolios. The case examines the implementation of centralized currency hedging overlays, which streamline FX risk management by using derivatives such as forwards, swaps, futures, and options to neutralize or reduce currency exposure. Currency hedging overlays separate FX risk management from the broader asset allocation process, enabling consistent, efficient, and transparent management of currency exposures across portfolios. The case emphasizes the importance of defining optimal hedging ratios and balancing risk reduction with hedging costs, including transaction fees, margin requirements, and opportunity costs. Factors such as currency volatility, correlations with portfolio assets, and interest rate differentials influence the choice of hedging instruments and the extent of hedging. By centralizing these decisions, institutions can enhance operational efficiency, reduce portfolio volatility, and better align currency management with investment objectives. The case also considers the decision between managing currency overlays internally or outsourcing to external specialists. Internal management offers greater control and customization but requires significant resources and expertise, while external managers provide specialized knowledge, cost efficiencies, and advanced monitoring tools. A hybrid approach, combining internal oversight with outsourced execution, can balance control and efficiency. Through detailed analysis, the case demonstrates how portfolio managers can design and implement effective currency hedging strategies that align with their operational capabilities, investment goals, and market conditions.