Currency Overlay Strategy Considerations

A global investment management firm, GlobalFunds, manages a diverse portfolio of international equity and fixed-income assets. As part of their risk management strategy, they have decided to implement a currency overlay program to better manage currency risk associated with these investments.

The firm is currently exposed to significant currency risk due to fluctuations in the value of the euro (EUR) and the Japanese yen (JPY) against the US dollar (USD). Their objective is to actively hedge this risk, aiming to enhance the overall portfolio returns while reducing volatility stemming from currency movements.

Discuss the key considerations GlobalFunds should evaluate when establishing their currency overlay strategy. In your response, address the following points: a) the rationale behind currency overlay, b) potential implementation approaches, and c) performance measurement metrics that should be used to assess the efficacy of the currency overlay. Be sure to incorporate relevant financial theories where appropriate.