The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
When constructing hedged interest rate arbitrage portfolios for basket currencies, two issues arise: first, how are the unknown future basket weights optimally forecasted from past exchange rate data? And, second, how is risk—in terms of the conditional variance of expected profits from the interest rate arbitrage portfolio—appropriately measured when the basket weights are time-varying? Answers to these questions are provided within a time-varying parameter modeling framework estimated through the Kalman filter. An empirical application is devoted to the experience of the Thai baht currency basket (January 1992–February 1997).