Back in the "old days" (ie 5-10 years ago) when we wanted to be long or short an emerging currency (say the ZAR, BRL, or TRY) we simply did everything against the pre-eminent currency of the day, the dollar. So for example to be long the Turkish Lira, we sold USDTRY. Short the rand, we bought USDZAR. Most of the return was attributable to the RHS of the pair.
Nowadays, the dollar is not the universally dominant hard currency, and so the relative strength or weakness of the USD itself "pollutes" a USD-EMFX position. In practise, for example, the correlation between EURUSD and USDXXX where XXX is an EM currency, has increased (in absolute terms):
Thus, if I am short USDZAR, I am significantly long of EURUSD through the correlation. The question is, how do I hedge this developed-currency cross rate risk out? How do I get back as close as possible to a pure-play on the emerging currency?
Obviously the answer will be that I have to fund my emerging currency position with a basket of hard currencies (candidates being say, USD, EUR, GBP, CHF, CAD, AUD, and JPY). But how do I best calculate the weights of this basket? Multiple regression of USDZAR against USDEUR, USDGBP, USDCHF, USDCAD, USDAUD, and USDJPY? Is that the right approach? Is there anything better? I've seen bloomberg using PCA for example in their Bloomberg Correlation Weighted Indices.