An asset manager has a mandate to manage a European equity portfolio for a U.S. pension client. The portfolio size is $100 million. The benchmark is some European equity index with a 50% currency hedging target. But the currency management is delegated to a currency overlay manager. The geographical breakdown of the portfolio on January 1 is as indicated below:
$$\begin{array} { l c c }
& \text { Value } & \text { Value } \
\text { Ey Country } & \text { in Lacal Currency } & \text { in Dallars } \
\hline \text { British Stacks } & \text { E.10 million } & \$ 15 \text { million } \
\text { Euraland Stacks } & \in 20 \text { million } & \$ 23 \text { million } \
\text { Swiss Stacks } & \text { SFr } 1.4 \text { millian } & \$ 1 \mathrm { million } \
\text { Total } & & \$ 38 \mathrm { million }
\end{array}$$ a. Assume that the currency overlay manager is neutral on currencies (that is, does not have specific forecasts on exchange rate). What would you expect the currency overlay manager to do on this portfolio?
b. Assume now that the currency overlay manager is bullish on the euro and pound but bearish on the Swiss franc (relative to the dollar). What kind of actions are you expecting from the currency overlay manager?

Question

An asset manager has a mandate to manage a European equity portfolio for a U.S. pension client. The portfolio size is $100 million. The benchmark is some European equity index with a 50% currency hedging target. But the currency management is delegated to a currency overlay manager. The geographical breakdown of the portfolio on January 1 is as indicated below:
 $$\begin{array} { l c c } 
& \text { Value } & \text { Value } \
\text { Ey Country } & \text { in Lacal Currency } & \text { in Dallars } \
\hline \text { British Stacks } & \text { E.10 million } & \$ 15 \text { million } \
\text { Euraland Stacks } & \in 20 \text { million } & \$ 23 \text { million } \
\text { Swiss Stacks } & \text { SFr } 1.4 \text { millian } & \$ 1 \mathrm { million } \
\text { Total } & & \$ 38 \mathrm { million }
\end{array}$$ a. Assume that the currency overlay manager is neutral on currencies (that is, does not have specific forecasts on exchange rate). What would you expect the currency overlay manager to do on this portfolio?
b. Assume now that the currency overlay manager is bullish on the euro and pound but bearish on the Swiss franc (relative to the dollar). What kind of actions are you expecting from the currency overlay manager?

Quizplus · Accepted Answer

The Answer is a. The currency overlay manager should try to align this portfolio with the benchmark. The target should be a 50% hedge ratio for all currencies. Hence, the currency overlay manager should sell forward (using forward or futures contracts) £5 million, €10 million, and SFr 700,000 against dollars.
This attitude assumes that the currency overlay manager is not responsible for the deviations of the portfolio's country weights relative to the benchmark's country weights. A more complex strategy would be to try to align the portfolio's currency weights with those of the benchmark. For example, assumes that Swiss equity have only a 2% weight in the European equity benchmark, while they have a 2.6% (2.6% F=1/38) in the portfolio; then the currency overlay manager could decide that the portfolio is overly exposed to the SFr and sell forward more
Swiss francs. In the benchmark, with a 50% hedge ratio, Swiss francs should only represent
1% =50% *2% of the portfolio. Hence, the SFr exposure of the portfolio should only be 1% of $38 million or $0.38 million. Given the 1.4 SFr/$ exchange rate, the SFr exposure should only
be SFr 532,000 = $0.38 million/1.4 SFr/$. So, the currency overlay manager would sell forward SFr 868,000 = SFr 1.4 million -SFr 532,000.
b. If the currency overlay has some specific forecasts, he will deviate from the neutral actions outlined above. For example, the currency overlay manager would sell forward less pounds and euros than outlined above and more Swiss francs. Active currency strategies could also involve currency options and dynamic strategies.

An Asset Manager Has a Mandate to Manage a European