The “Forward Premium Puzzle” and the Sovereign Default Risk

Virginie Coudert () and Valérie Mignon ()

Working Papers from CEPII research center

Abstract: Carry-trade strategies which consist of buying forward high-yield currencies tend to generate positive excess returns during long periods of time. Here, we aim at explaining this puzzle by the default risk, which is frequently taken on by investing in high-yield currencies. 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 models, we show that default risk fuels the carry-trade gains during periods of upbeat financial markets, and worsens the losses in bear markets. We then introduce the default risk into the “Fama regression” linking the exchange-rate depreciation to the interest-rate differential. The “forward bias”, usually evidenced by a coefficient smaller than unity in this regression, is somewhat alleviated, as the default risk partially explains the excess return.

Keywords: Carry trades; Forward premium; UIP puzzle; Default risk; Smooth transition regression models (search for similar items in EconPapers)
JEL-codes: C30 G01 G15 (search for similar items in EconPapers)
Date: 2011-07
New Economics Papers: this item is included in nep-fmk and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Related works:
Journal Article: The “forward premium puzzle” and the sovereign default risk (2013)
Working Paper: The ‘Forward Premium Puzzle’ and the Sovereign Default risk (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:cii:cepidt:2011-17

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