This article studies cross-hedging to reduce foreign exchange risk and tests its effectiveness in the currencies of developing countries. This group of countries is very heterogeneous : they differ greatly with regard to geographic location, size, economic development and market conditions.
In the result of the test, we find that the hedging effectivenesses are also differ greatly between those currencies. Though some currencies show high effects, the other currencies show adverse effects. In those countries, the correlation between assets is biased by the monetary authority's exchange control which prevents intermarket triangular relationships. As the result of it, there is no true correlation between assets.
The constant hedge ratio over time is also important for the hedging effectiveness. En-ante cross-hedge ratio is estimated in a prior period and is applied to the subsequent period. When it is vary from time to time, it may not be true hedge ratio to the subsequent period. And it results to expand the exchange risk rather than to reduce the risk.
Cross-hedging is successful when the next three conditions are satisfied : the true correlation between assets, the accuracy of estimates of risk- minimizing hedge ratio and the stability of the true hedge ratio over time.
