Understanding Passive Currency Overlay


The world of Foreign Exchange continues to evolve and expand rapidly, at least in terms of global daily average turnover[1]. This evolution is fundamentally due to:

  • The structure of the market: continued consolidation among the market players.

  • The composition of the market participants: currency overlay managers and traditional asset managers are joined by hedge funds, high-frequency traders and retail aggregators.

  • The new technologies: new electronic platforms and networks are used as well as new services and technologies such as STP and CLS which have added efficiency to the end-to-end trade flow while limiting the risks.

This is happening in the context of a recent financial crisis (2008) where changes and uncertainty have brought a mixed of good and bad news to investors including the opportunity to have a fresh look at the currency risk management policy: whereas some may opt for a more conservative approach, other investors may try to capture the newly emerged opportunities.

This document might be the very first step towards the challenging process of setting up a sensible currency risk management policy.

 Currency Overlay Strategies

The below section focus on the major characteristics of the Currency Overlay Strategies.

As described on the figure 1, we have in one side the passive currency overlay strategy, aiming purely at offsetting the risk, while, on the other side active strategies try to also benefit from FX market fluctuations to add an incremental return to the Portfolio.

While the Asset Manager is responsible for implementing the equity or fixed income strategy, the FX management will generally be outsourced to an FX Overlay provider.


 Passive hedging

The objective of a passive overlay strategy is strictly to eliminate the risk. This strategy does not try to add any additional return to the portfolio.

A complete hedge of the currency exposure is implemented and will convert the total foreign currency exposure back into the fund base currency.

 Dynamic hedging

While passive overlay only focus on risk elimination, the Dynamic strategy also seeks to benefit from market fluctuations. These strategies will adjust their hedge dynamically following a set of predefined rules.

When passive strategy used a fix target hedge ratio (such as 100%) to rebalance the hedge, here the hedge ratio will be variable. The FX Overlay provider will fully hedge the currency exposures when the market moves again the underlying position and will decrease the hedge ratio to a predefined level (e.g. 50%) when the market moves in favor.

 Active Currency Overlay

While for dynamic hedging strategies, the target hedge ratio is governed by a predefined set of rules, active hedging strategies will tactically hedge and un-hedge the position depending on the environment.

As highlighted on the left-hand side of the Figure 2 below, when foreign currencies are depreciating against the fund base currency the best option is to adopt a 100% hedged position. Conversely, on the right-hand side of the chart, when foreign currencies are appreciating against the fund base currency the best option is to adopt an unhedged (i.e. 0% hedged) position. This situation, described as the ideal outcome is the objective that an active hedging strategy tries to achieve.

As further describe in the next section, this figure also highlights the main disadvantage of a passive hedging strategy: the larger the appreciation in a foreign currency, the further away will be the passive hedging outcome from the gain that would have been achieved following the “ideal outcome line”.


Figure 2: Active currency overlay and strategy return[2]

Focus on Passive Currency Overlay

Rationale for choosing a passive hedging strategy

First of all, for a portfolio manager, while investing in international assets can be part of its strategy, it can result in foreign currency exposure. Hedging this exposure to specific currencies can significantly improve a portfolio's performance.

In addition, for investors, exchange rates can have a significant impact on their returns. For example, if a EUR investor buy shares in an UK equity fund denominated in GBP, its returns in EUR will be influenced by movements in the GBP/EUR exchange rate.

Indeed, if the EUR strengthens against the GBP, its returns will be lower than the GBP return once the investment is converted back into EUR. Conversely, the returns will be higher than the GBP return if the EUR weakens against the GBP. Therefore, unless a hedge is put in place, investor returns are fully exposed to currency risk or “unhedged”.

In order to attract foreign investors uncomfortable with unhedged currency exposure, fund managers have launched 'hedged share classes' in locally denominated currencies. These shares classes enable the investors to invest in their own local currency while, at the same time, minimize FX currencies fluctuations impact thanks to the implementation of a passive hedge.

In conclusion, on the one hand the main benefit of a passive currency overlay strategy is to protect the portfolio from any adverse movements in foreign currencies. This risk reduction gives the opportunity for investors to take additional risk by investing in other asset classes. In addition, the fees are usually lower than for dynamic and active strategies.

 On the other hand, a main disadvantage is that the hedge completely removes the foreign currency exposure and therefore also eliminates the diversification and its benefits when the FX Market fluctuations moves in favor of the underlying position.

 How to implement the hedge?

In order to put in place a passive currency overlay, the asset manager or the FX overlay provider will most often use futures, forwards and swaps[3] instruments to hedge their exposure. The aim of these derivatives will be to lock in the exchange rate between the foreign currencies and the fund base currency over the life of the derivative contract.

 In practice, when an investor subscribes into a hedged share class the following transactions take place:

The FX overlay provider converts the purchases of a hedged share class into the fund base currency at the spot rate by executing a FX SPOT. As part of the same contract, the base currency exposure will be hedged at the forward foreign exchange (FX) rate by executing a FX FORWARD.

The daily gain or loss on the currency hedge remains un-invested (or unrealized) until the hedge is rolled over.

At contract settlement, the hedge is rolled over (generally on a monthly or quarterly basis), meaning that the asset manager or FX overlay provider will enter into another contract that locks in the exchange rate. At this time, the profit or loss is crystalized (realized) and becomes part of the Net Asset Value (NAV) of the related hedged share class.

 In addition, in order to mitigate counterparty risk, when a profit or loss (realized or not) is made the fund may have to transfer additional cash or other liquid assets to the counterparty as collateral.

 Criteria to select the target hedge ratio

Sensitivity to negative cash flows & transaction costs

A passive currency overlay implies the settlement of a hedging profit or loss at the derivative contract settlement when the hedge is rolled over. In case of important FX market fluctuation a large cash payment can be required from the fund to settle its hedging loss.

A higher target hedge ratio leads to a greater potential negative cash flows to settle a hedging loss. As a consequence, a fund sensitive to cash flows will have to assess the maximum hedge ratio that it is able to tolerate.

In addition, the size of the leeway (tolerance interval accepted for the hedge ratio) has an impact on the transaction costs. The smallest the leeway (ex: 99.5% -100.5%), the more often FX transactions will take place to keep the hedge ratio in this range and the higher the transactions costs.

Fixed income vs Equity

As highlighted in the chart below, currency risk has a much larger impact on overall volatility for bonds rather than equities.

For that reason asset managers have usually decided to adopt higher strategic hedge ratios for international bonds portfolio rather than for International equities portfolio.



              Figure 3: Currency risk within international bond and equity portfolio[4]

ESMA Guidelines for Passive Currency Overlay

As part of its opinion released in 2017, the European Securities and Markets Authority (ESMA) made recommendations on over and under-hedged positions. UCITS management company should ensure that over-hedged positions do not exceed 105% as well as under-hedged position do not fall under  95% of the Net Asset Value of an hedged share class.

 Trends and Challenges on PCO Market


Currency Overlay Market

The period 2010-2015 saw a steady growth of 20% CAGR[5]. The market is foreseen to keep the same trend boosted by asset diversification (asset hedging) and distribution expansion (share class hedging).


Currency overlay and especially the passive currency overlay is evolving from a ‘nice to have’ to a ‘must have’ service. In addition, the product offering is growing: besides the share class hedging, asset hedging is getting more and more popular within asset managers and new products such as look-through hedging and ‘early termination’ are requested by the customers.

 Efficiency and Quality

Customers require a more transparent and higher quality execution and MIFID II is expected to partially meet these expectations as it tackles these two dimensions. Measuring the performance of the hedging program is also becoming a key differentiator.


FX Market

The WMR (FX market rate fixing) scandal in 2015 has impacted the reputation of the FX market, hence potentially the currency overlay business. Although the MIFID II regulation might have limited the negative impact, the daily average turnover has dropped from USD 5,357 billion in 2013 to 5,067 in 2016 which represents a 5.4% [6]decrease.

 Regulatory aspects

Product restrictions potentially imposed at share class level

 As part of its mission to enhance investor protection and promote stable and orderly financial markets, the European Securities and Markets Authority (ESMA) touched on this topic by launching a Consultation and finally sharing its Opinion in January 2017.

 While the UCITS Directive covers UCITS funds and compartments, it stays silent on the definition and scope of share classes, only recognizing their existence in passing. There is therefore as yet no common legal or regulatory framework for share classes throughout the EU.

 The goal of this opinion (or guidelines) seems to be to limit the complexity and additional exposures at share class level in order to protect investors and avoid any spill over to other share classes.

 The high-level 4 principles which UCITS must follow when setting up different share classes in order to ensure a harmonised approach across the EU are:

  • Common investment objective

  • Non-contagion

  • Pre-determination

  • Transparency


The Market in Financial Instruments Directive II (MIFID II) aims to close the gaps in financial market regulation revealed by the 2008 financial crisis.

 More specifically, this directive aims to adapt the legislation to changes in financial markets, both financially and technologically since Directive 2004/39/EC on markets in financial instruments (MiFID implemented in 2007).

 The main objective is to make financial markets more resilient and transparent, while strengthening investor protection and providing authorities with more effective supervisory powers. The date of application of the new regulatory framework was 3 January 2018.

 The directive focuses on the investor protection, the best execution, trading transparency and post trade reporting. Ten months after the transposition deadline, 25 countries out of 28 (89%[7]) have fully transposed it into their national law. However it is too soon to assess the results and the constraints/ benefits on the market players, especially the currency overlay ones.

 FX hedging execution models: principal vs agency execution

The FX trading industry has been historically using the principal trading model, meaning the bank is trading with its client itself and taking on the risks.

 However, in the context of MIFID II and the ‘best execution’ policy, the industry is rapidly heading toward an agency-only trading model, meaning essentially the bank act as a broker for their clients.

 As a consequence of this model change, Overlay service providers will have to adapt their product offering.


 The attractiveness of a passive currency overlay results from its simplicity and its relatively low fees and transaction costs in comparison to more dynamic currency management strategies.

 On one hand, asset managers (asset hedging) and investors (share class hedging) are protected from any adverse movements in foreign currencies. On the other hand, they cannot benefit when FX Market fluctuations move in favor of their position.

 Expectations regarding Passive Currency Overlay Market evolution are positive. Indeed, the market should achieve a steady growth in the coming years boosted by asset diversification (asset hedging), distribution expansion (share class hedging) and new products launch (‘early termination’).

Nonetheless, asset managers and FX overlay providers will also have to deal with regulatory challenges (MIFID II, ESMA guidelines) as well as new requirements from the investors (reporting transparency and a shift toward an agency execution model).

About the author


Nelson Dossogne,, has 6 years’ experience in  the Banking sector  with a specialization in the Fund Industry. As Senior Consultant for Initio Brussels since 2016, he developed expertise in Passive Currency Overlay, supporting clients on regulatory adaptations, operational process reviews and credit risk monitoring tools development. 


Yilmaz Tunc, has 13 years’ experience in the Telecom and Fund industry sectors. As a Senior Consultant he helped international telecom customers to address telecom pricing optimization challenges, provided telecom industry training and developed expertise in Passive Currency Overlay expertise in serving customers, managing a production team and structuring the operations.


Table 1: Foreign exchange market turnover by instrument [8]



Figure 4: Foreign exchange market turnover by instrument (daily average in April)[9]




Bank for International Settlements (BIS), “Triennial Central Bank Survey”, September 2016

Blackrock,”BlackRock Global Funds (BGF) & BlackRock Premier Funds (BPF), Hedged Share Classes Explained”, 2018

BNP Paribas Securities Services, “Passive Currency Overlay Report”, September 2018

Credit Suisse, “An Introduction to Currency Management Solutions”, September 2017

Credit Suisse, “Efficient Currency Management – More Important Than Ever”, March 2017

Deloitte, “Passive Currency Overlay – Trends and Challenges facing the hedging market”, Performance magazine issue 20, January 2016

European Commission, “MIFID II Directive Transposition Status”, last updated on 27th September 2018,  https://ec.europa.eu/info/publications/mifid-ii-directive-transposition-status_en

European Securities and Market Authorities (ESMA), “Opinion on Share classes of UCITS”, 30th January 2017

HSBC Foreign Exchange Overlay & Funds Europe Magazine, “To outsource or not to outsource currency risk management”, 14th May 2018

Insight Investment, “Currency Risk Management –A guide for Australian Supeannution Fund Trustees”, March 2017

J.P. Morgan Asset Management, “Currency-hedged share classes: A guide for investors”, January 2018

Marquette Associates, prepared by Gregory J. Leonberger, FSA, Director of Research, “Understanding Currency Overlay”, July 2010

Millenium Global, “Currency Solutions Overview”, website , consulted on 16th September 2018, https://www.millenniumglobal.com/currency-solutions-overview


[1] See Annex : Table 1 and Figure 4 “Foreign exchange market turnover by instrument”

[2] Source: Insight Investment, 2017

[3] See Annex : Table 1 and Figure 4 “Foreign exchange market turnover by instrument”

[4] Source : Millenium global, September 2018

[5] Source: BNP Paribas Securities Services, September 2018

[6] See Annex : Table 1 and Figure 4 “Foreign exchange market turnover by instrument”

[7] Source : European Commission, September 2018

[8] Source: BIS Triennial Central Bank Survey, September 2016

[9] Source: BIS Triennial Central Bank Survey, September 2016