Interest-Rate Arbitrage in Currency Baskets: Forecasting Weights and Measuring Risk.

We use a time series modeling approach to address two related questions of interest to foreign-exchange market participants and policy makers dealing with basket currencies. First, how are unknown weights appropriately extracted from basket currencies? Second, how does one correctly account for the risk--in terms of conditional variance of expected profits--that time-varying weights add to the standard basket-hedge position? We suggest a methodology that can provide answers to these questions and apply it to the heavily traded Thai baht currency basket.