Options in an overlay
The aim of a currency overlay programme is not only to protect portfolios from unfavourable currency movements. It can also add return through active management strategies.
The return of a currency overlay programme is contingent on the price evolution of the underlying currencies. It makes possible a wide variety of patterns of returns tailored to a client’s needs. In that respect a currency overlay programme can itself be classified as a derivative, if we define a derivative as a security whose price ultimately depends on that of another asset (the underlying).
Several distinct strategies are employed by currency overlay managers: quantitative, technical, fundamental or volatility-based. These strategies can be combined to provide customised programmes for international investors. Whatever his style of investment, a currency specialist has to actively manage volatility. The off-benchmark positions, and consequently the tracking error relative to the investment policy benchmark, are directly influenced by the changing volatility of the underlying currencies. For that reason, based on his proprietary indicators and currency modelling system, the manager may use derivatives, such as currency options, to enhance performance.
Under certain market conditions, using options can be a valuable approach to generating alpha, provided that the manager maintains a consistent and rigorous risk control process. We believe the use of options can add value and significantly improve the risk/return of the diversified portfolios of strategies used in the global currency management programme.
The following examples highlight circumstances under which a currency manager using options can have a more optimum risk/reward profile than can be provided by traditional strategies.
When currency markets lack any trend or are in a prolonged period of low volatility, most strategies generate poor performance and make it difficult to hedge effectively while maintaining profit potential relative to the benchmark. In this environment an option portfolio can produce superior returns as the cost, level of protection and profit potential can be tailored, including by using both standard and exotic options.
In highly volatile markets, on the other hand, as the price of the option is directly influenced by currency volatility, option costs will be high. But the true volatility is sometimes even higher than that reflected in option prices, leading the currency manager to avoid hedging costs he would have faced using traditional methods.
Of course, the real answer to the obvious question – “is the price worth paying?” – will not be known for some time. Our experience shows that buying out-of-the-money options, for instance, can be a useful and cost-effective way to hedge against risks that have very low probabilities, but which when they do occur have disproportionate costs to the global hedging programme. (This phenomenon is known by options traders as “wing buying” – buying protective out-of-the-money options.)
More generally, the success of using currency options in overlay programmes depends on how well the managers are able to integrate the features of options strategies within the global hedging model and to construct reliable indicators to apply them under different market opportunities. The manager must have an extensive knowledge of option behaviour, including that of the more complex second-generation products, such as barrier or binary options, where the pay-off profile may be path-dependent.
Options traders know the difficulty of predicting the final P/L when they hedge themselves (rebalance the gamma) to replicate the pay-off of an option. As currency overlay managers are partially replicating the payoff of an option, it seems logical to be able to integrate options into the hedging process.
The implementation of the programme needs to take into account all the components of the options portfolio with pre-defined strategies, stoplosses and a specific money management system. The computerised test should then show that a disciplined approach using option combinations as hedging tools is valuable at appropriate times.
Our own research and track record conclude that a well-run option model can be effective and is likely to generate excess return to the main system, on a risk-adjusted basis. Whether used to avoid excessive market volatility or to produce alpha in trendless markets, the low correlation of the option-based model to the commonly used quantitative methodology makes for efficient model diversification in a currency management system.
Hélie d’Hautefort is managing director of Overlay Asset Management in Geneva