Working Paper: NBER ID: w16427
Authors: Hanno Lustig; Nikolai Roussanov; Adrien Verdelhan
Abstract: We describe a novel currency investment strategy, the 'dollar carry trade,' which delivers large excess returns, uncorrelated with the returns on well-known carry trade strategies. Using a no-arbitrage model of exchange rates we show that these excess returns compensate U.S. investors for taking on aggregate risk by shorting the dollar in bad times, when the U.S. price of risk is high. The counter-cyclical variation in risk premia leads to strong return predictability: the average forward discount and U.S. industrial production growth rates forecast up to 25% of the dollar return variation at the one-year horizon. The estimated model implies that the variation in the exposure of U.S. investors to world-wide risk is the key driver of predictability.
Keywords: currency risk; carry trade; risk premia; forward discount
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| economic downturns (F44) | dollar carry trade excess returns (F31) |
| low US short-term interest rates (E43) | long on foreign currencies (F31) |
| declines in industrial output (L16) | higher expected returns on foreign currencies (F31) |
| average forward discount (H43) | excess returns (D46) |
| US industrial production growth (N12) | excess returns (D46) |