Working Paper: CEPR ID: DP6873
Authors: Craig Burnside; Martin Eichenbaum; Isaac Kleshchelski; Sergio Rebelo
Abstract: Currencies that are at a forward premium tend to depreciate. This `forward-premium puzzle' is an egregious deviation from uncovered interest parity. We document the properties of the carry trade, a currency speculation strategy that exploits this anomaly. This strategy consists of borrowing low-interest-rate currencies and lending high-interest-rate currencies. We first show that the carry trade yields a high Sharpe ratio that is not a compensation for risk. We then consider a hedged version of the carry trade, which protects the investor against large, adverse currency movements. This strategy, implemented with currency options, yields average payoffs that are statistically indistinguishable from the average payoffs to the standard carry trade. We argue that this finding implies that the peso problem cannot be a major determinant of the payoff to the carry trade.
Keywords: carry trade; exchange rates; uncovered interest parity
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| peso problems (I32) | returns to the carry trade (F32) |
| currencies at a forward premium (F31) | depreciation (D25) |
| carry trade yields high Sharpe ratio (G15) | not merely a compensation for risk (G19) |
| average payoffs to hedged carry trade (G15) | indistinguishable from unhedged carry trade (G19) |
| peso problems (I32) | significant portion of the returns (G11) |
| traditional asset pricing models (G12) | fail to rationalize high average payoffs (C79) |
| peso events (F31) | average payoffs (J33) |