The Returns to Currency Speculation

Craig Burnside (), Martin Eichenbaum (), Isaac Kleshchelski and Sergio Rebelo ()

No 864, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: Currencies that are at a forward premium tend to depreciate. This `forward premium-depreciation anomaly' represents an egregious deviation from uncovered interest parity. We document the returns to currency speculation strategies that exploit this anomaly. The first strategy, known as the carry trade, is widely used by practitioners. This strategy involves selling currencies forward that are at a forward premium and buying those that are at a forward discount. The second strategy relies on a particular regression to forecast the payoff to selling currencies forward. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. However, these Sharpe ratios do not represent unexploited profit opportunities. In the presence of microstructure frictions, spot and forward exchange rates move against traders as they increase their positions. The resulting `price pressure' drives a wedge between average and marginal Sharpe ratios. We argue that marginal Sharpe ratios are zero even though average Sharpe ratios are positive. We display a simple microstructure model that simultaneously rationalizes `price pressure' and the forward premium-depreciation puzzle. The central feature of this model is that market makers face an adverse selection problem that is less severe when, based on public information, the currency is expected to appreciate

Keywords: uncovered interest parity; BGT regressions; price pressure (search for similar items in EconPapers)
JEL-codes: G12 G13 G15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mon and nep-mst
Date: 2006-12-03
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Related works:
Working Paper: The Returns to Currency Speculation (2006)
Working Paper: The Returns to Currency Speculation (2006)
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