The effectiveness of cross-currency hedging

This study examines the effectiveness of cross-currency hedging compared to that of forward hedging and money market hedging. It is demonstrated that cross-currency hedging is not only less effective than forward and money market hedging but also that it is totally ineffective unless the exchange rate of the exposure currency and that of the third currency are highly correlated. The results indicate that for an effective crosscurrency hedging a correlation coefficient of 0.50 is required. This kind of correlation reduces the variance of the rate of return on the unhedged position by about 25 per cent.