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The Term Structure of Currency Carry Trade Risk Premia

  • Hanno Lustig
  • Andreas Stathopoulos
  • Adrien Verdelhan

We find that average returns to currency carry trades decrease significantly as the maturity of the foreign bonds increases, because investment currencies tend to have small local bond term premia. The downward term structure of carry trade risk premia is informative about the temporal nature of risks that investors face in currency markets. We show that long-maturity currency risk premia only depend on the domestic and foreign permanent components of the pricing kernels, since transitory currency risk is automatically hedged by interest rate risk for long-maturity bonds. Our findings imply that there is more cross-border sharing of permanent than transitory shocks.

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File URL: http://www.nber.org/papers/w19623.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19623.

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Date of creation: Nov 2013
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Handle: RePEc:nbr:nberwo:19623
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  11. Lewis, Karen K., 2000. "Why do stocks and consumption imply such different gains from international risk sharing?," Journal of International Economics, Elsevier, vol. 52(1), pages 1-35, October.
  12. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
  13. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  14. Bansal, Ravi, 1997. "An Exploration of the Forward Premium Puzzle in Currency Markets," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 369-403.
  15. Chernov, Mikhail & Graveline, Jeremy & Zviadadze, Irina, 2012. "Sources of Risk in Currency Returns," CEPR Discussion Papers 8745, C.E.P.R. Discussion Papers.
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