Idiosyncratic Consumption Risk and Predictability of the Carry Trade Premium: Euro-Area Evidence

Abstract:     
The failure to empirically prove uncovered interest rate parity conditions seems to be related to the presence of risk premia on foreign currencies. Recent studies suggest that either consumption- or currency-return-based pricing factors explain the cross section of foreign currency portfolio returns. The contribution of this paper is twofold. It first shows that the return-based explanation applies to foreign currency portfolios built from the perspective of a Euro-Area investor. Second, the main results of this paper suggest that the decisive pricing factor, the so-called carry trade premium, mirrors business-cycle-related risks. Times of relatively large uninsured Euro-Area consumption growth risk are associated with an expected increase of the carry trade premium.

Keywords: Consumption risk sharing, Foreign currency returns, Return predictability, Uncovered interest rate parity

JEL Classification: F31, G10, G15

Accepted Paper Series