Hedging and Arbitrage when the Base Currency is Pegged to a Basket

Abstract

This paper examines hedging and arbitrage in the foreign exchange market, in the particular case of the base currency being pegged to a basket. The sources of foreign exchange risk arising from taking long and short positions on a multi-currency portfolio are identified, and the findings are used to design some hedging and arbitrage rules. These rules make it possible to minimize foreign exchange risk arising from a long position on a portfolio, and to arbitrage the interest rate differential by taking either short or long positions on the portfolio. Some empirical evidence on the hedging rules is presented using the SDR as a base currency.