Cross-hedging Effectiveness in Emerging Markets Experiencing Structural Change

Abstract

When an investor is unable to implement a direct hedge, a cross-hedge can be an effective alternative. This is particularly pertinent to emerging market currency investments as currencies are less likely to have exchange-traded currency derivatives. This study examines the performance of full, minimum variance and error correction model hedges during the 1997 East Asian currency crisis. While the minimum variance and error correction hedges were effective on average, the full hedge gave superior results during periods where currencies were undergoing structural change. It may be preferable to implement a full hedge when structural change is anticipated. Little support is found for the use of error correction model hedges, indicating that while cointegration may exist, and while there may be in-sample statistical support for their use, out-of-sample performance of such hedges is less than assured.