Mean/Variance Analysis of Currency Overlays

Global investors are now paying more attention to the management of the currency risks of their portfolios. Some have started to delegate currency management to managers. These managers use currency futures and forwards to minimize the risks or maximize the returns of the underlying asset portfolios. The overlay structure is inherently suboptimal because it ignores interactions between the assets in the underlying portfolio and exchange rates. Based on historical data, the efficiency loss appears to be on the order of 40 basis points for equity portfolios. This loss, of course, must be balanced against any excess returns that may be generated by specialized overlay managers. Simulated results over the 1978-91 period indicate that overlay management can add value to global equity and bond portfolios. It cannot enhance performance by as much as an integrated approach to currency management, however.