The ‘Forward Premium Puzzle’ and the Sovereign Default risk

Carry-trade strategies which consist of buying forward high-yield currencies tend to yield positive excess returns when global financial markets are booming, whereas they generate losses during crises. Firstly, we show that the sovereign default risk, which is taken on by investing in high-yield currencies, may increase the magnitude of the gains during the boom periods and the losses during crises. We empirically test for this hypothesis on a sample of 18 emerging currencies over the period from June 2005 to September 2010, the default risk being proxied by the sovereign credit default swap spread. Relying on smooth transition regression (STR) models, we show that default risk contributes to the carry-trade gains during booms, and worsens the losses during busts. Secondly, we turn to the "Fama regression" linking the exchange-rate depreciation to the interest-rate differential. We propose a nonlinear estimation of this equation, explaining the puzzling evolution of its coefficient by the change in the market volatility along the financial cycle. Then, we introduce the default risk into this equation and show that the "forward bias", usually evidenced by a coefficient smaller than unity in this regression, is somewhat alleviated, as the default risk is significant to explain the exchange-rate change.