DP7348 The Exchange Rate Effect of Multi-Currency Risk Arbitrage

Author(s): Harald Hau

Publication Date: June 2009

Keyword(s): Limited Arbitrage , Speculative Trading , Multi-Currency Risk Hedging , Spectral Inference , Cospectrum

JEL(s): F31 , G11 , G14 , G15

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP7348.asp.asp

This paper documents how currency speculators trade when international capital flows generate predictable exchange rate movements. The redefinition of the MSCI world equity index in December 2000 provides an ideal natural experiment identifying exogenous capital flows of index tracking equity funds. Currency speculators are shown to front-run international capital flows. Furthermore, they actively manage the portfolio risk of their speculative positions through hedging positions in correlated currencies. The exchange rate effect of separate risk hedging is economically significant and amounts to a return difference of 3.6 percent over a 5 day event window between currencies with high and low risk hedging value. The results of the classical event study analysis are confirmed by a new and more powerful spectral inference isolating the high frequency cospectrum of currency pairs. The evidence supports the idea that international currency arbitrage is limited by the speculators' risk aversion.