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Do Peso Problems Explain the Returns to the Carry Trade?

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Listed:
  • 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.

Suggested Citation

  • Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891.
  • Handle: RePEc:oup:rfinst:v:24:y:2011:i:3:p:853-891
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    File URL: http://hdl.handle.net/10.1093/rfs/hhq138
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    References listed on IDEAS

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    1. David Altig & Lawrence Christiano & Martin Eichenbaum & Jesper Linde, 2011. "Firm-Specific Capital, Nominal Rigidities and the Business Cycle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(2), pages 225-247, April.
    2. Taylor, Mark P, 1987. "Covered Interest Parity: A High-Frequency, High-Quality Data Study," Economica, London School of Economics and Political Science, vol. 54(216), pages 429-438, November.
    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.
    4. Clinton, Kevin, 1988. "Transactions Costs and Covered Interest Arbitrage: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 358-370, April.
    5. David Altig & Lawrence Christiano & Martin Eichenbaum & Jesper Linde, 2011. "Firm-Specific Capital, Nominal Rigidities and the Business Cycle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 14(2), pages 225-247, April.
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    JEL classification:

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

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