Learning Outcomes
After reading this article, you will recognize the distinction between strategic and tactical currency hedging for institutional and portfolio investors. You will be able to explain when and why currency risk is managed by long-term policy positions or by short-term active overlays. You will understand how currency hedges are established, monitored and rebalanced, and recognize common pitfalls and exam-critical concepts for CFA Level 3.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand the application of currency risk management policies for global portfolios. When revising this area, focus on:
- The difference between strategic (policy-based) and tactical (active overlay) currency hedging
- Factors influencing benchmark hedge ratios and permitted hedging ranges
- The motives for and approaches to currency overlay implementation
- The operational process for managing currency hedges (instruments, monitoring, and rebalancing)
- Implications for portfolio risk and return under various hedging regimes
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- What is the primary distinction between a strategic and a tactical currency hedge?
- List two factors that could influence the benchmark hedge ratio for an institutional portfolio.
- Give one reason why a manager might temporarily deviate from the policy hedge ratio.
- What implementation risks could arise with frequent tactical FX overlay adjustments?
Introduction
Currency risk is a key concern for investors with exposure to foreign assets. How that risk is managed—through long-term strategic policies or via flexible tactical overlays—shapes both performance and operational complexity. For CFA Level 3, you are expected to assess when each approach is appropriate, how policies are set and implemented, and how real-world constraints and manager views can drive hedging outcomes.
Key Term: strategic currency hedge
A long-term or default FX hedge ratio set as part of a portfolio’s investment policy, typically reviewed infrequently and intended to anchor currency exposures regardless of short-term market views.Key Term: tactical currency overlay
An active, short-term adjustment to the portfolio’s FX hedge position, typically based on manager convictions or market signals, within boundaries set by policy.
STRATEGIC HEDGING POLICIES
Strategic hedging, often termed a "benchmark hedge," defines a portfolio’s neutral or standard hedge ratio for managing FX risk. For example, an institutional investor might declare a 50% hedge benchmark for all developed market currencies and a 100% hedge benchmark for high volatility minor currencies.
The strategic hedge is chosen to reflect investor objectives, risk tolerance, asset-liability needs, and relevant long-term beliefs. Strategic hedges seek to anchor FX exposures over time and minimize the need for constant re-evaluation.
Key Considerations:
- Strategic hedge ratios may be set at 0% (fully unhedged), partial (e.g., 50%), or 100% (fully hedged).
- They should be chosen based on long-term asset allocations, investment horizon, funding and spending requirements, and regulatory or IPS constraints.
- Policy defines not only the benchmark hedge but also a permitted deviation range (e.g., 50% hedge ±20%).
Exam Warning A common CFA exam error is confusing a currency overlay “mandate” (which can be delegated to an active manager) with the investment policy’s hedge “range.” The range sets firm limits regardless of manager view.
TACTICAL HEDGING POLICIES
Tactical (or active) hedging overlays allow managers to adjust currency exposure opportunistically within the limits set by policy. The goal is to add value by increasing or decreasing the FX hedge ratio when forward rates, carry, or macro views are viewed as especially favorable or unfavorable.
Tactical hedging is usually implemented using short-dated forwards, futures, or options. The overlay manager may take views based on interest differentials, carry signals, or fundamental factors, typically within a range (e.g., permitted deviation from the benchmark of ±10% or ±20%).
Active overlays aim to capture incremental alpha from market mispricings, mean reversion, or tactical signals, but introduce implementation challenges and operational risks.
Key Implementation Features:
- Deviation from the benchmark (policy) FX hedge must remain within permitted bounds.
- Execution tactics, choice of instruments, and trade frequency all require monitoring for transaction and slippage costs.
- Overlay positions are monitored, marked to market, and require tight controls to avoid policy breaches.
Worked Example 1.1
A global endowment holds €100 million in USD and JPY assets. Its policy FX hedge benchmark is 50%, with a range of 30% to 70%. In mid-year, the portfolio manager believes the dollar will strengthen and decides to lower the USD hedge ratio to 30%. What is allowed, and what steps should the manager take?
Answer:
The manager may tactically lower the USD hedge to 30%—the lower limit of the policy range. The change must be documented, justified using the manager’s process and market views, implemented using approved FX instruments, and closely monitored to ensure that the hedge ratio returns to at least the 50% benchmark or remains within the permitted range as policy dictates.
BENCHMARK HEDGE RATIOS AND RANGE POLICIES
The benchmark hedge ratio—the percentage of FX exposure to be hedged as policy—is set to balance long-term risk and return objectives. It determines the default level of FX risk, and typically a formal deviation policy is also established for permitted tactical activity.
Main Policy Approaches:
- Fully Unhedged (0% hedge): Accepts all FX risk. Suitable for those seeking long-term international diversification, or if FX exposures are expected to mean revert over long horizons.
- Partial Hedge (e.g., 50%): Balances participation in currency moves with some protection from adverse FX moves.
- Fully Hedged (100% hedge): Eliminates FX risk versus the base currency, often used when short-term funding or liabilities are sensitive to FX.
The permitted deviation or tactical range (e.g., ±20%) is essential to set clear risk boundaries and avoid over-reliance on manager market timing.
Worked Example 1.2
A pension fund’s IPS specifies that FX overlay managers may vary the EUR hedge between 20% and 80% of non-base assets. The current hedge is 60%. If the overlay manager wishes to exploit an expected EUR rally, what is their minimum permitted hedge?
Answer:
The lowest the manager can set the EUR hedge is 20%—the lower policy bound. The overlay manager documents their rationale, implements the change using approved derivatives, and ensures compliance with the permitted range.
HEDGING IMPLEMENTATION AND OPERATIONAL CONSIDERATIONS
Strategic and tactical hedges are executed using instruments such as FX forwards, futures, and options. The choice of instrument, hedge horizon, and rebalancing frequency depend on liquidity, transaction costs, operational capabilities, and policy limits.
Key Term: currency overlay
An explicit mandate or program where FX exposures are managed, often by a specialist, separate from the core asset allocation or main portfolio manager.Key Term: hedge ratio
The percentage of foreign currency exposure (from assets or liabilities) hedged to the investor’s base currency, typically defined as a proportion of total FX risk.
Rebalancing: Both strategic and tactical overlays must be monitored for drift due to market moves. Regular rebalancing is required to keep the hedge ratio near the policy or tactical target.
Worked Example 1.3
A fund holds $200 million of foreign equities with 100% policy FX hedges. Forward contracts are rolled monthly but a sharp equity rally causes the FX exposure to double before the next scheduled rebalance. What is the risk?
Answer:
The fund is under-hedged relative to policy until the next hedge roll or rebalance. This exposes the fund to FX gains/losses outside the intended risk. Frequent monitoring and appropriate trade sizing are required to minimize tracking error and unintentional policy breaches.
Exam Warning
In the CFA exam, expect scenarios where benchmark and tactical hedge ratios, allowable ranges, and overlay execution policies are tested together. Clearly distinguish between long-term policy and short-term tactical changes.
POLICY TRADEOFFS AND PRACTICAL LIMITATIONS
Strategic vs Tactical Approach—Checklist:
- Strategic (policy) hedging is appropriate where risk budgets are tight, funding or obligations are in the base currency, or for investors seeking stable real portfolio values.
- Tactical overlays are appropriate for investors able to absorb some FX volatility to exploit market opportunities or for those seeking diversification/alpha.
- Tighter bands (e.g., ±10%) reduce deviation risk but also limit opportunity.
- Wider bands permit more alpha seeking, but risk greater tracking error or policy breach.
Operational Challenges:
- Overlays add transaction and monitoring costs.
- Slippage, roll risk, and option premium costs can erode any tactical alpha.
- Systems must track exposures, resets, and policy compliance across multiple FX instruments and counterparties.
Revision Tip
When answering CFA questions, always cite the IPS policy, hedge ratio, and permitted range before outlining a tactical hedge change or overlay decision. Provide a justification linked to risk, return, and policy constraints.
Summary
Effective currency risk management for global portfolios requires clear separation of:
- Strategic policy hedges (long-term, anchored in investment objectives)
- Tactical overlays (short-term, alpha seeking within policy bands) Managers must implement hedges through approved instruments, monitor exposures in real time, and strictly conform to policy ranges to manage portfolio risk and compliance.
Key Point Checklist
This article has covered the following key knowledge points:
- Distinction between strategic (long-term policy) and tactical (active overlay) FX hedging
- Benchmark hedge ratios define default policy exposure; permitted ranges define oversight boundaries
- Tactical currency overlays seek incremental value but introduce monitoring and implementation risks
- Real-world FX hedge management requires frequent exposure reviews and prompt rebalancing
- Hedging policy should be grounded in IPS, with operational discipline for compliance
Key Terms and Concepts
- strategic currency hedge
- tactical currency overlay
- currency overlay
- hedge ratio