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

Abstract

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.

JEL Classification: C53, F31