Interest-rate arbitrage in currency baskets: Forecasting weights and measuring risk

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 extrac ted 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 methodolog y that can provide answers to these questions and apply it to the heavily t raded Thai baht currency basket.