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Idiosyncratic Consumption Risk and Predictability of the Carry Trade Premium: Euro Area Evidence

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Author Info
Thomas Nitschka
Abstract

The empirical failure of the uncovered interest rate parity condition seems to be the reflection of risk premia on foreign currencies. After the formation of foreign currency portfolios according to interest rate differentials or forward discounts, recent studies suggest that either consumption- or currency return-based pricing factors explain the cross-section of foreign currency portfolio returns. The contribution of this paper is twofold. It shows that the returnbased explanation applies to foreign currency portfolios sorted from the perspective of a Euro Area investor. Secondly, the main results of this paper suggest that the decisive pricing factor, the so called carry trade premium, mirrors business cycle related risks. Times of relatively large amounts of uninsured Euro Area consumption growth risk are associated with an expected increase of the carry trade premium.

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Paper provided by Institute for Empirical Research in Economics - IEW in its series IEW - Working Papers with number iewwp387.

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Date of creation: Sep 2008
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Handle: RePEc:zur:iewwpx:387

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Related research
Keywords: Consumption risk sharing; foreign currency returns; return predictability; UIP;

Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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