The authors develop the optimal trading strategy for a Foreign Exchange (FX) broker who must liquidate a large position in an illiquid currency pair. To maximize revenues, the broker considers trading in a currency triplet which consists of the illiquid pair and two other liquid currency pairs. The liquid pairs in the triplet are chosen so that one of the pairs is redundant.
The broker is risk-neutral and accounts for model ambiguity in the FX rates to make her strategy robust to model misspecification. When the broker is ambiguity neutral (averse) the trading strategy in each pair is independent (dependent) of the inventory in the other two pairs in the triplet. The authors employ simulations to illustrate how the robust strategies perform. For a range of ambiguity aversion parameters, they find the mean Profit and Loss (P&L) of the strategy increases and the standard deviation of the P&L decreases as ambiguity aversion increases. This is the first paper that shows how FX brokers manage large positions in currency pairs. The framework can be extended to FX trading algorithms
to make markets and those designed to take speculative positions in currency pairs with strong co-dependence.
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