Working Paper: NBER ID: w12489
Authors: Craig Burnside; Martin Eichenbaum; Isaac Kleshchelski; Sergio Rebelo
Abstract: Currencies that are at a forward premium tend to depreciate. This 'forward-premium puzzle' represents an egregious deviation from uncovered interest parity. We document the properties of returns to currency speculation strategies that exploit this anomaly. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. In practice bid-ask spreads are an increasing function of order size. In addition, there is price pressure, i.e. exchange rates are an increasing function of net order flow. Together these frictions greatly reduce the profitability of currency speculation strategies. In fact, the marginal Sharpe ratio associated with currency speculation can be zero even though the average Sharpe ratio is positive.
Keywords: Currency speculation; Forward premium puzzle; Uncovered interest parity; Sharpe ratios
JEL Codes: E24; F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forward premium status (G13) | currency depreciation (F31) |
| order size (C69) | bid-ask spreads (G19) |
| bid-ask spreads (G19) | profitability (L21) |
| net order flow (F02) | exchange rates (F31) |
| exchange rates (F31) | profitability (L21) |
| price pressure (D41) | relationship between trading strategies and profitability (L10) |