The exchange rate effect of multi-currency risk arbitrage

• The paper examines the structure of exchange rate arbitrage strategies.
• Multicurrency strategies should feature cross-sectional hedging.
• The FX impact of such hedging is shown to be important.
• Spectral methods are developed to identify multicurrency trading.
• Hedging strategies contribute to the FX disconnect puzzle.

Carry trade arbitrage strategies typically involve multiple currencies. Limits to arbitrage in such a setting not only slow the adjustment to the fundamental equilibrium, but can also generate transitory over- or undershooting of each exchange rate in accordance with the marginal risk contribution of each speculative position to the overall arbitrage risk. The paper uses a natural experiment to identify a particular global arbitrage opportunity and shows that arbitrage risk hedging modifies the exchange rate dynamics in the predicted manner. New spectral methods are applied to obtain a more precise inference on the cross-sectional trading pattern of the arbitrageurs.