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

•The ability to use derivatives can be limited by trading costs and liquidity risks.•Greater wealth allocation in countries with liquid and low cost derivative markets.•Developing derivative markets could beneficial for greater foreign investment.

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.