Working Paper: CEPR ID: DP7348
Authors: Harald Hau
Abstract: 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.
Keywords: cospectrum; limited arbitrage; multicurrency risk hedging; spectral inference; speculative trading
JEL Codes: F31; G11; G14; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk hedging component of arbitrage (G13) | currency returns (F31) |
| risk management in speculation (D84) | exchange rate dynamics (F31) |
| capital reallocations (E22) | exchange rates (F31) |
| changes in index weights (C43) | exchange rate movements (F31) |
| currency speculators frontrun international capital flows (F31) | predictable exchange rate movements (F31) |