Synthetic money: addressing the budget-constraint issue

Kunkler, M. (2023) Synthetic money: addressing the budget-constraint issue. International Journal of Finance & Economics, 28 (4). pp. 3774-3788. ISSN 1099-1158 doi: 10.1002/ijfe.2618

Abstract/Summary

A synthetic currency attempts to mimic a target currency with an optimal portfolio of other currencies, without having a position in the target currency. The original construction methodology of a synthetic currency imposed a budget constraint such that the portfolio weights sum to a non-zero value, say. However, a synthetic currency is a portfolio of invariant currency indexes, rather than a portfolio of currency positions. In this article, we show that invariant currency indexes are tradable multilateral exchange rates. Consequently, the sum-to-x budget constraint unintentionally creates a non-zero position in the target currency. We address this budget-constraint issue by replacing the sum-to-x budget constraint with a sum-to-zero budget constraint, which correctly enforces a zero position in the target currency. Once the budget-constraint issue is addressed, investors are faced with the fact that synthetic money is unable to mimic significant currency-specific movements in target currencies.

Item Type	Article
URI	https://reading-clone.eprints-hosting.org/id/eprint/113550
Identification Number/DOI	10.1002/ijfe.2618
Refereed	Yes
Divisions	Arts, Humanities and Social Science > School of Politics, Economics and International Relations > Economics
Publisher	Wiley-Blackwell
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