Currency overlay, the process by which institutional clients are able to overlay the expertise of currency managers on currency exposures inherent in international investing, has become a necessary part of investment management globally as funds increasingly invest abroad.
As with any other investment area, there are multiple styles that can be adopted and investors have been advised to adopt a diversified strategy to capture the lack of correlation across these strategies. However, unlike other investment areas, the choices in the currency markets have been limited to relatively few firms (less than 20 global players) and even less diversification across styles.
As most consultants and practitioners have discovered, currency overlay styles for developed market currencies were bucketed into three basic strategies:
q fundamental, or managers who used economic and financial data to make predictions on likely currency moves;
q technical, or managers who evaluate currency price data to examine trends and cycles; and
q volatility-based, where managers have tried to replicate the payoff of an option by trading based on analyses of volatility.
All three styles typically have used only forward contracts to execute their strategies. Further, the volatility-based managers (or ‘risk-control’ managers) have argued that currency markets cannot be accurately forecast and hence have not targeted excess returns over the benchmark in their strategy. However, trading volatility through forward contracts is inefficient as it runs the risk that large gapping moves in the spot rate or volatility leave the portfolio position out of line with the prevailing volatility environment.
This article demonstrates that the industry has not exploited useful financial instruments – currency options – to add return and diversify risks of currency overlay programmes. As a result, investors, especially larger investors, have concentrated the risk of their overlay programme into a limited set of styles. We demonstrate how they can increase diversity in these programmes and raise return-risk ratios through the use of options strategies. Further, currency options are the most efficient way to trade volatility in currency markets and this enhances the ability to execute such strategies. Future research will demonstrate the additional diversification benefit of adding emerging market currencies.
First, we briefly describe the currency overlay styles that seek to add value and develop an options strategy that can enhance any overlay programme that uses these styles. As a result, we ignore the options replications or risk-controlled styles.
Fundamental managers work on the principle that every currency pair has a ‘fair value’ that is driven by the demand and supply of currencies. The factors that influence whether a currency is cheap or expensive include relative inflation differentials, relative interest rates, trade positions, equity valuations and other economic variables such as commodity prices. In the parlance of the equity world, these are the ‘value’ managers. However, the simplest ‘fundamental’ strategy that generates substantial value is based on the notion that the investors should buy high and/or rising interest rate currencies and sell low and/or falling interest rate currencies. Variants of this strategy, known as the ‘carry’ strategy, have been shown to make money over long economic cycles. This strategy makes money, but has the potential to make large losses when markets turn risk-averse and hence an enhanced carry strategy is recommended for clients. Here, we have developed a simple model that buys high interest rate currencies and sells low interest rate currencies, and that cancels this trade when our proprietary indicator on risk-aversion is triggered. We will call this the carry strategy and, in table 1, show the results of such an optimised strategy for US dollar/yen for January 1998– October 2001.
Technical managers work on the premise that analysing economic data requires paradigms about currency markets that may lose information and hence currency prices are adequate to predict currency markets. They exploit the fact that currency markets trend and move in cycles and hence simple trend-following strategies have been shown to be very profitable. These rules are shown to work across different currency pairs and over long and short periods.
In table 1, we demonstrate a naïve trend strategy for dollar/yen for the same period. An interesting observation has been that fundamental and technical styles do not correlate very highly and hence combining the two styles, either through a single manager or through multiple managers, has proved to be valuable. Technical managers will have difficulty when markets are moving sideways, that is, in trendless markets.
A new alpha options strategy has been devised with a number of interesting properties. First, the strategy is created as an overlay to the other overlay styles to prevent the portfolio from being levered (ie, there are underlying spot positions for every option trade and hence no leverage). Second, the strategy has positive return. Third, the strategy is designed to work in markets where the technical strategies struggle and hence is negatively correlated with the technical strategy. Finally, the strategy is designed to be uncorrelated with the fundamental strategy. The performance of this strategy for $/¥ is provided in table 1, and the correlations across the strategies are provided in table 2.
We created three portfolios that combine the various styles. Portfolio 1 is the traditional portfolio that combines equal proportions of the fundamental and technical style. Portfolio 2 combines the fundamental and the options strategy equally and portfolio 3 combines all three in equal proportions. The performance of these portfolios for $/¥ is reported in table 3 and, as one would expect, given the performance of these styles and the correlations, portfolio 3 has the best return-risk ratio, substantially outperforming the traditional portfolio 1. The same is true across other currency pairs, suggesting that the portfolio effect will be substantial. Clearly, a naïve combination of styles adds significant value and clients will find that optimised multiple manager styles will provide substantial additional value.
Clients have already recognised the benefits of combining fundamental and technical styles and this is demonstrated in our tables. We have extended the analysis of diversification and demonstrated that investors can improve their return-risk ratios by incorporating a stylised alpha options strategy, to complement fundamental and technical managers they may have already hired. These strategies make use of an underused security, options, to take advantage of an under-exploited market feature, volatility. In so doing, these strategies provide valuable diversification to investor portfolios and greatly improve the return-risk ratios. Future research will demonstrate the advantage of including emerging market currencies to further diversify the performance of overlay programmes.
Arun Muralidhar is managing director and Harish Neelakandan is head of options at FX Concepts in New York

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