The Exchange Rate Effect of Multi-Currency Arbitrage
Journal of International Money and Finance, Vol. 47 (2014), 304-331

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.

Additional Files

Powerpoint slides of a seminar presentation are available here.