While each agreement between institutional investors and their currency manager is unique, for discussion purposes, it is useful to consider first the types of mandates that are in common use and some of their key features and second, other structural and operational choices that differentiate mandates. By varying these contractual parameters, institutional investors influence their expected alpha (what we call the alpha continuum) as well as their exposure to risk.
There are two basic types of currency mandates. In an absolute return mandate, the investor seeks to earn a positive return, usually in excess of some benchmark, and is subject to acceptable risk levels. With a currency overlay mandate, on the other hand, the investor already owns a portfolio of foreign debt or equity and the objective of the mandate is either to entirely eliminate currency risk from the portfolio or only partially reduce currency risk while opportunistically going after return.4
In both absolute return and currency overlay mandates, the agreement will specify how much latitude the manager has to operate, identify provisions that constrain the manager, and, of course, spell out how the manager's performance will be determined and the formula for setting compensation. The main considerations stipulated in a currency mandate will include the following.