Evaluating Currency Overlay Strategies for XYZ Pension Fund

XYZ Pension Fund is an institutional investor with a substantial international portfolio consisting of equities and fixed income assets diversified across numerous currency exposures, including USD, EUR, JPY, and AUD. Recently, the fund has faced increased volatility in currency markets due to geopolitical tensions and shifting monetary policies in key economies. To manage these currency risks effectively while pursuing enhanced returns, the fund's management is considering implementing a currency overlay strategy.

Your task is to discuss the key components of a currency overlay strategy, detailing how it can be implemented in this context. In your answer, evaluate the potential benefits and risks associated with currency overlays, referencing relevant theories such as hedging effectiveness and the impact of correlations between currencies and underlying economic fundamentals. Additionally, assess how the currency overlay strategy can be aligned with the fund's overall investment objectives and risk tolerance to optimize its effectiveness.