Do Peso Problems Explain the Returns to the Carry Trade?

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

No 6873, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Currencies that are at a forward premium tend to depreciate. This `forward-premium puzzle' is an egregious deviation from uncovered interest parity. We document the properties of the carry trade, a currency speculation strategy that exploits this anomaly. This strategy consists of borrowing low-interest-rate currencies and lending high-interest-rate currencies. We first show that the carry trade yields a high Sharpe ratio that is not a compensation for risk. We then consider a hedged version of the carry trade, which protects the investor against large, adverse currency movements. This strategy, implemented with currency options, yields average payoffs that are statistically indistinguishable from the average payoffs to the standard carry trade. We argue that this finding implies that the peso problem cannot be a major determinant of the payoff to the carry trade.

Keywords: Carry trade; Exchange rates; Uncovered interest parity (search for similar items in EconPapers)
JEL-codes: F31 (search for similar items in EconPapers)
Date: 2008-06
New Economics Papers: this item is included in nep-cba and nep-ifn
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (46)

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Related works:
Journal Article: Do Peso Problems Explain the Returns to the Carry Trade? (2011)
Working Paper: Do Peso Problems Explain the Returns to the Carry Trade? (2010)
Working Paper: Do Peso Problems Explain the Returns to the Carry Trade? (2008)
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