Cross hedging currency risk from frontier/emerging markets: Thai portfolio investors' perspectives

Abstract

The study explored performances of cross-hedging emerging/frontier market currency risk with developed market currencies from Thai investors’ perspective. The results showed that Thai investors can use a cross-hedging strategy to reduce currency risk and improve risk adjusted return from their emerging market investment. Single cross hedging can reduce portfolio risk significantly as confirmed by the F-test. Multiple cross-hedging showed signs of improvement from single cross-hedging both in currency risk reduction and risk adjusted return improvement, but the statistical test failed to prove that the improvement is significant. While the portfolio return was penalized by the hedging cost. The risk reduction justified the hedging cost and improved risk adjusted return performance indicators; Sharpe ratio and Sortino ratio. The improvement was confirmed by standard paired bootstrap test of the ratios.

The study also revealed that, in some cases, Ederington hedge effectiveness and Sharpe/Sortino ratio can be contradicting, both measures must be considered before making a hedging decision. When investment risk is significantly higher than the FX risk, the improvement will not be as prominent as when investment risk and FX risk are in the same level. Thus, in this study, cross-hedging bond investment showed more significant risk adjusted return than stock investment. In our study, the rebalancing strategy affects the cross-hedging performance, 3-month rebalancing strategy produced a significantly higher risk adjusted return than 1-month rebalancing strategy. Sharpe ratio and Sortino ratio were equally effective and always went in the same direction. The results are sensitive to market conditions and situations, thus selection of recent data set and continuous monitoring in the actual implementation of currency cross-hedging will be crucial.