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The Exchange Rate Effect of Multi-Currency Risk Arbitrage

  • Hau, Harald

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7348.

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Date of creation: Jun 2009
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Handle: RePEc:cpr:ceprdp:7348
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  1. Evans, Martin D. D. & Lyons, Richard K., 2002. "Informational integration and FX trading," Journal of International Money and Finance, Elsevier, vol. 21(6), pages 807-831, November.
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  8. Torben G. Andersen & Tim Bollerslev & Francis X. Diebold & Clara Vega, 2002. "Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange?," Center for Financial Institutions Working Papers 02-23, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  24. Harald Hau & Hélène Rey, 2004. "Can Portfolio Rebalancing Explain the Dynamics of Equity Returns, Equity Flows, and Exchange Rates?," American Economic Review, American Economic Association, vol. 94(2), pages 126-133, May.
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