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Do Peso Problems Explain the Returns to the Carry Trade?

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Author Info
Burnside, A Craig
Eichenbaum, Martin
Kleshchelski, Isaac
Rebelo, Sérgio

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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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6873.

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Date of creation: Jun 2008
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Handle: RePEc:cpr:ceprdp:6873

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Related research
Keywords: carry trade; exchange rates; Uncovered interest parity;

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F31 - International Economics - - International Finance - - - Foreign Exchange

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Clinton, Kevin, 1988. "Transactions Costs and Covered Interest Arbitrage: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 358-70, April. [Downloadable!] (restricted)
  2. David E. Altig & Lawrence J. Christiano & Martin Eichenbaum & Jesper Linde, 2004. "Firm-specific capital, nominal rigidities, and the business cycle," Working Paper 0416, Federal Reserve Bank of Cleveland. [Downloadable!]
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  3. A. Craig Burnside, 2007. "Empirical Asset Pricing and Statistical Power in the Presence of Weak Risk Factors," NBER Working Papers 13357, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Zsolt Darvas, 2008. "Leveraged carry trade portfolios," Working Papers 0802, Department of Mathematical Economics and Economic Analysis, Corvinus University of Budapest, revised 18 Jun 2008. [Downloadable!]
    Other versions:
  2. Aidan Corcoran, 2009. "The Determinants of Carry Trade Risk Premia," The Institute for International Integration Studies Discussion Paper Series iiisdp287, IIIS. [Downloadable!]
  3. Stephen Gilmore & Fumio Hayashi, 2008. "Emerging Market Currency Excess Returns," NBER Working Papers 14528, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  4. Menkhoff, Lukas & Sarno, Lucio & Schmeling, Maik & Schrimpf, Andreas, 2009. "Carry Trades and Global FX Volatility," MPRA Paper 14728, University Library of Munich, Germany. [Downloadable!]
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