The exchange rate effect of multi-currency risk arbitrage

This paper (i) proposes a simple multi-currency model of speculative foreign exchange (FX) trading, (ii) uses a natural experiment to identify the implied components of the optimal trading strategy, and (iii) proposes a new spectral inference method to strengthen the statistical evidence on the predicted shortrun exchange rate dynamics. Cross-sectional currency hedging effects are shown to be qualitatively large in their price impact and can contribute to the disconnect between exchange rates and fundamentals. Speculation ; Limited Arbitrage ; Hedging ; Exchange Rate Disconnect