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Risk-Premia, Carry-Trade Dynamics, and Speculative Efficiency of Currency Markets

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  • Christian Wagner

    (Oesterreichische Nationalbank)

Abstract

Foreign exchange market efficiency is commonly investigated by Fama-regression tests of uncovered interest parity (UIP). In this paper, we conjecture a speculative UIP relationship which implies that exchange rate changes comprise a time-varying risk component in addition to the forward premium.This suggests that the forward premium anomaly reported in previous research potentially stems from omitting this component in UIP tests and that the popular carry-trade strategy can be rationalized to some extent. Moreover, while related work focuses on the Fama-regression slope coefficient, we show that also the intercept is important for judging the economic significance of currency speculation. Empirically, we find support for speculative UIP and the existence of a risk-premium. Furthermore, although carry-traders are able to collect some risk-premia, currency speculation does not yield economically significant excess returns, which suggests that foreign exchange markets are speculatively efficient. Disregarding the Fama-regression constant, however, leads to distortions in the assessment of economic significance and induces spurious rejection of speculative efficiency.

Suggested Citation

  • Christian Wagner, 2008. "Risk-Premia, Carry-Trade Dynamics, and Speculative Efficiency of Currency Markets," Working Papers 143, Oesterreichische Nationalbank (Austrian Central Bank).
    • Handle: RePEc:onb:oenbwp:143
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    References listed on IDEAS

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    Cited by:

    1. Stocker, Marshall L., 2016. "The price of freedom: Idiosyncratic currency devaluations," Research in International Business and Finance, Elsevier, vol. 38(C), pages 312-325.
    2. Jylhä, Petri & Suominen, Matti, 2011. "Speculative capital and currency carry trades," Journal of Financial Economics, Elsevier, vol. 99(1), pages 60-75, January.
    3. Matti Suominen & Petri Jylhä, 2009. "Arbitrage Capital and Currency Carry Trade Returns," 2009 Meeting Papers 84, Society for Economic Dynamics.
    4. Dr. Matthias Gubler, 2014. "Carry Trade Activities: A Multivariate Threshold Model Analysis," Working Papers 2014-06, Swiss National Bank.

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    More about this item

    Keywords

    Exchange rates; Uncovered interest parity; Speculative efficiency; Risk-premia; Carry-trade.;
    All these keywords.

    JEL classification:

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

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