Article ID Journal Published Year Pages File Type
964668 Journal of International Money and Finance 2014 28 Pages PDF
Abstract

•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.

Related Topics
Social Sciences and Humanities Economics, Econometrics and Finance Economics and Econometrics
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