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The exchange rate effect of multi-currency risk arbitrage |
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| Affiliation: | 1. Cornell S.C. Johnson College of Business, Cornell University, USA;2. Judge Business School, Cambridge University, UK;1. University of Cyprus, Department of Mathematics & Statistics, Po Box 20537, Nicosia 1678, Cyprus;2. Centre for Research and Technology, Institute of Applied Biosciences Po Box 60361, Thessaloniki 57001, Greece;1. University of Hohenheim, Department of Economics, Schloss Hohenheim 1C, 70593 Stuttgart, Germany;2. Università di Roma Tor Vergata, Dipartimento di Economia e Finanza, Via Columbia 2, 00133 Rome, Italy;3. CREATES, Aarhus University, Department of Economics and Business Economics, Fuglesangs Allé 4, DK-8210 Aarhus V, Denmark |
| Abstract: | 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. |
| Keywords: | Speculation Limited arbitrage Hedging Exchange rate disconnect G11 G14 G15 |
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