The effectiveness of hedging foreign exchange rate risk: an emerging market perspective

Abstract

This study provides an analysis of the effectiveness of the foreign currency hedging abilities afforded by the futures market. The focus is on the currencies of six emerging markets, namely; Brazil, India, Mexico, Russia, South Africa and Turkey. By examining emerging market currencies we can examine the effect that possible mispricing and lack of liquidity can have on hedging effectiveness. To this effect, this article uses the regression method, as allowed by the accounting standard FAS 133, to assess the effectiveness of futures contracts as a hedging mechanism for emerging market currencies. The methods follow previous studies such as Hill and Schneeweis (1982) which consider the length of the hedging horizon and time to expiration due to their effect on hedge effectiveness. Results indicate consistent hedge effectiveness in only South Africa and Turkey, with reasonable hedge effectiveness exhibited by Mexico and Russia. Sensible explanations are given for the extreme hedge ineffectiveness that can be seen in the Brazilian and Indian tests.