DP6873 Do Peso Problems Explain the Returns to the Carry Trade?

Author(s): Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski, Sérgio Rebelo
Publication Date: June 2008
Keyword(s): carry trade, exchange rates, Uncovered interest parity
JEL(s): F31
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6873

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.