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

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  • Thapa, Chandra
  • Neupane, Suman
  • Marshall, Andrew

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 the 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 that provide liquid and cost-effective opportunities for using FXD. Our results suggest that regulatory reforms aimed at developing FXD markets could be a potential policy measure for attracting higher levels of foreign equity portfolio investments.

Suggested Citation

  • Thapa, Chandra & Neupane, Suman & Marshall, Andrew, 2016. "Market liquidity risks of foreign exchange derivatives and cross-country equity portfolio allocations," Journal of Multinational Financial Management, Elsevier, vol. 34(C), pages 46-64.
    • Handle: RePEc:eee:mulfin:v:34:y:2016:i:c:p:46-64
    DOI: 10.1016/j.mulfin.2016.01.001
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    More about this item

    Keywords

    Foreign equity portfolio allocations; Foreign exchange derivatives; Market liquidity risks;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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