Market liquidity risks of foreign exchange derivatives and cross-country equity portfolio allocations

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Abstract

Foreign exchange derivatives (FXD) are important tools for hedging foreign exchange (FX) risks and enhancing returns of international portfolios. However, the ability to use FXD can be constrained by higher trading costs and the liquidity risks of FXD available in different markets/currencies across countries. In this study, we investigate whether the wide cross-sectional and temporal variations observed in the liquidity level of FXD markets are associated with the cross-country allocation decisions of foreign portfolio investors. Using an extensive dataset of 40 countries and a number of alternative specifications, our study finds that investors tend to allocate more wealth in countries which provide liquid and cost-effective opportunities of using FXD. Our results imply that regulatory reforms aimed at developing FXD markets could be a potential policy measure for attracting higher levels of foreign equity portfolio investments.
Original languageEnglish
Pages (from-to)46-64
Number of pages19
JournalJournal of Multinational Financial Management
Volume34
Early online date13 Jan 2016
DOIs
Publication statusPublished - 1 Mar 2016

Keywords

  • foreign equity portfolio allocations
  • foreign exchange derivatives
  • market liquidity risks

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