19.2. ACTIVE CURRENCY OVERLAY

19.2.1. Common Strategies

Common active currency overlay strategies include currency alpha, carry strategies, momentum strategies, flow strategies, valuation strategies, and quantitative currency overlay. We describe each of these below.

19.2.1.1. Currency Alpha

Active investing is a zero-sum game. For every winner, there must by definition be a loser. Given that active management creates transaction costs, the average manager should underperform the market. This is well known as the arithmetic of active management introduced by Sharpe (1991). While the active equity manager has on average underperformed major indices, the active currency manager seems to have outperformed as studies summarized by Dales and Meese (2003) report. Who is supplying net alpha to active currency investor; that is, who is implicitly transferring wealth? The usual folklore is that the currency market is dominated by so-called forced players that have nonprofit objectives. Central banks are said to have more macroeconomic policy objectives, corporate treasuries are more interested in corporate hedging, and tourists are treated as entirely ignorant to currency valuations. Care should be taken. The above-cited studies have neither been undertaken nor confirmed by independent sources as they are originated by players that have a strong interest in active currency management. Moreover, contrary to the conventional wisdom, it is well known that central banks make profits, corporate hedging does not lose money, and tourist flows follow currency weakness.