Rates Equities and Portfolio Forwards · Forwards Trading Guide

A currency overlay manages exchange rate exposure separately from choosing stocks or bonds. Its result must be evaluated together with the underlying portfolio.

Separate asset and currency decisions

A U.S. investor holding European shares has exposure to their local market value and to EUR/USD. Selling EUR forward can reduce the currency component without selling the shares. It does not protect against a fall in the shares themselves. Define whether the mandate targets a stable hedge ratio, a tactical currency position or another documented objective.

Size the starting hedge

Suppose the portfolio is worth EUR 2 million and the approved illustrative hedge ratio is 50%. Selling EUR 1 million forward matches that starting target. If the portfolio falls to EUR 1.6 million while the forward notional remains unchanged, the ratio becomes 62.5%. The portfolio value changes even when no currency trade is made.

Follow cash availability

When the home currency weakens, a short foreign currency hedge can lose while the translated value of the foreign assets rises. The portfolio may still need cash to settle the forward or meet collateral calls without selling assets at a convenient time. Economic offset and cash liquidity are separate problems. Keep reserves and funding rules consistent with the overlay policy.

Review the full return

Measure foreign asset performance, exchange rate translation, forward settlements, costs and any cash interest separately before combining them. For an unhedged position, local asset and currency returns compound multiplicatively. A 10% local gain and 5% currency gain produce 15.5%, not exactly 15%. With hedging, use actual cash flows and changing notionals rather than mechanically subtracting a headline currency return.

Try it yourself

A portfolio’s foreign currency value rises from EUR 4 million to EUR 5 million while its EUR 2 million forward sale is unchanged. What is the new hedge ratio?

Show the worked answer

40%. The hedge remains EUR 2 million, but it now covers a smaller fraction of the EUR 5 million portfolio.

Further reading

Educational material. Numerical examples are hypothetical and exclude costs unless stated. Forward contracts create binding obligations and may require collateral or credit approval. Actual terms, access and risks depend on the agreement and jurisdiction.

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