Cross-hedging currency risks in Asian emerging markets using derivatives in major currencies - A free lunch?

Ever larger proportions of portfolio investments are being directed to emerging markets with underdeveloped derivatives markets. This study documents the effectiveness of cross-hedging currency risks for investments in seven Asian emerging markets using futures and options in widely available and more liquid developed country currencies. The authors document that overlay policies for such cross-hedging of Asian emerging market investments can reliably improve portfolio performance and Sharpe performance indexes, and hedge ratios based on prior periods are stable enough to be useful. As expected, for many of these emerging Asian currencies, the most effective hedging instruments are generally Japanese yen derivatives.