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Carry Trade: Beyond the Forward Premium Puzzle

  • Tarek Hassan

    (The University of Chicago)

We show that the Carry Trade exploits a static interest rate differential which is largely unrelated to the fact that currencies whose interest rates exceed their long-run average tend to appreciate (the Forward Premium Puzzle). The evidence is consistent with the presence of a static risk premium: investors are permanently more averse to being exposed to the exchange rate risk associated with particular countries. However, we find no evidence that bilateral currency risk premia vary over time. Instead, the forward premium puzzle is a statistical correlation that does not predict economic returns. We show that abnormal returns in foreign exchange markets can be explained in a parsimonious model in which there are permanent differences in the cross-section of currency risk premia and all currency risk premia against the US Dollar move together over time.

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Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 124.

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Date of creation: 2012
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Handle: RePEc:red:sed012:124
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Web page: http://www.EconomicDynamics.org/society.htm
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