DoPesoProblemsExplainTheReturnsToTheCarryTrade - Do Peso...

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Unformatted text preview: Do Peso Problems Explain the Returns to the Carry Trade? & Craig Burnside y , Martin Eichenbaum z , Isaac Kleshchelski x , and Sergio Rebelo { January 2010 Abstract We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payo/s which are on average large and uncorrelated with tra- ditional risk factors. We investigate whether these payo/s re&ect a peso problem. We argue that they do. We reach this conclusion by analyzing the payo/s to the hedged carry trade, in which an investor uses currency options to protect himself from the downside risk from large, adverse movements in exchange rates. J.E.L. Classication: F31 Keywords: Uncovered interest parity, exchange rates, carry trade. & This paper is a substantially revised version of NBER Working Paper 12489 titled The Returns to Currency Speculation.We thank the editor, Geert Bekaert, two anonymous referees, John Cochrane, John Heaton, Jakub Jurek, and Ravi Jagannathan for very useful comments. We also thank the Chicago Mercantile Exchange for providing us with the currency-options data used in this paper. Burnside is grateful to the National Science Foundation for nancial support (SES-0516697). y Duke University and NBER. z Northwestern University, NBER, and Federal Reserve Bank of Chicago. x Washington University in Saint Louis. { Northwestern University, NBER, and CEPR. 1 Introduction The forward exchange rate is a biased forecaster of the future spot exchange rate. This fact is often referred to as the &forward-premium puzzle.In this paper we study the properties of a widely-used currency speculation strategy that exploits this puzzle. The strategy, known as the carry trade, involves selling currencies forward that are at a forward premium and buying currencies forward that are at a forward discount. Transaction costs aside, this strategy is equivalent to borrowing low-interest-rate currencies in order to lend high-interest- rate currencies, without hedging the associated currency risk. Consistent with results in the literature, we nd that the carry-trade strategy applied to portfolios of currencies yields high average payo/s, as well as Sharpe ratios that are substantially higher than those associated with the U.S. stock market. The most natural interpretation for the high average payo/ to the carry trade is that it compensates agents for bearing risk. However, we show that linear stochastic discount factors built from conventional measures of risk, such as consumption growth, the returns to the stock market, and the Fama-French (1993) factors, fail to explain the returns to the carry trade. This failure reects the absence of a statistically signicant correlation between the payo/s to the carry trade and traditional risk factors. Our results are consistent with previous work documenting that one can reject consumption-based asset-pricing models using data on...
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This note was uploaded on 10/26/2010 for the course JOHNSON 6730 taught by Professor Georgegao during the Fall '10 term at Cornell University (Engineering School).

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DoPesoProblemsExplainTheReturnsToTheCarryTrade - Do Peso...

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