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Do Peso Problems Explain the Returns to the Carry Trade?

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  • Craig Burnside
  • Martin Eichenbaum
  • Isaac Kleshchelski
  • Sergio Rebelo

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 payoffs that are on average large and uncorrelated with traditional risk factors. We argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oxfordjournals.org, Oxford University Press.

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Bibliographic Info

Article provided by Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 24 (2011)
Issue (Month): 3 ()
Pages: 853-891

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Handle: RePEc:oup:rfinst:v:24:y:2011:i:3:p:853-891

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  1. David Altig & Lawrence J. Christiano & Martin Eichenbaum & Jesper Linde, 2004. "Firm-specific capital, nominal rigidities and the business cycle," Working Paper Series, Federal Reserve Bank of Chicago WP-05-01, Federal Reserve Bank of Chicago.
  2. A. Craig Burnside, 2010. "Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors," Working Papers, Duke University, Department of Economics 10-45, Duke University, Department of Economics.
  3. Clinton, Kevin, 1988. "Transactions Costs and Covered Interest Arbitrage: Theory and Evidence," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 96(2), pages 358-70, April.
  4. Taylor, Mark P, 1987. "Covered Interest Parity: A High-Frequency, High-Quality Data Study," Economica, London School of Economics and Political Science, London School of Economics and Political Science, vol. 54(216), pages 429-38, November.
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