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Citi Perspectives for the Public Sector
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2015 – 2016
47
Currency Overlay in
Reserve Management
Currency overlay has long been used by institutional
investors to enhance returns and diversify holdings of
international asset portfolios. In this article we look at
how central banks could use carry, trend and value
concepts to manage currency exposures of international
reserve holdings.
Kristjan Kasikov
Director,
CitiFX Quantitive
Investor Solutions,
Citi
Broadly speaking, currency overlay refers to active management of currency risk, which
disconnects currency exposures from asset allocation decisions. This can range from variation of
hedge ratios on foreign currency exposures to taking long-short positions in currencies that the
underlying portfolio does not contain or even trading currency volatility.
Active management offers investors opportunities to have flexible and more profitable currency
exposures without having to shift underlying assets. Many examples such as the one considered
later in this article show that currency management can add uncorrelated return, i.e. does not
necessarily lead to an increase in the volatility of the overall portfolio. This is because factors
used to determine optimal currency exposures are often unrelated to the drivers of traditional
assets and much of global FX trading is purely transaction-driven, allowing returns from active
management to persist.
Although our anecdotal evidence suggests that some central banks invest with currency managers
and several manage currencies in-house, interest in currency management among reserve
managers has traditionally been lower than among institutional investors. Arguments for this range
from lack of market access and uncertain returns to negligible impact on the overall portfolio.
In this article we try to address all these questions using the example of a practical overlay to
demonstrate potential value added.
First, currencies are the most liquid financial instruments in the world with more than USD 5 trillion
traded globally per day according to the latest survey from the Bank for International Settlements.
1
With intelligent execution methods such as CitiFX Intelligent Orders, even large customers such as
central banks can access the market with little or no execution slippage.
Moreover, “active” currency management does not have to be too active. The CitiFX Beta
strategies, which capture carry, momentum and value factors or ‘risk premia’ in the most liquid
developed market currencies, only check signals 12 times a year. Each signal check does not
necessarily lead to a trade.
1
The BIS Triennial Central Bank Survey, April 2013 preliminary results http://www.bis.org/publ/rpfx13fx.pdf
For Institutional Investors Only — Not for Onward Distribution
Active
management
offers
investors
opportunities
to have
flexible
and more
profitable
currency
exposures
without
having
to shift
underlying
assets.