The Term Structure of Currency Carry Trade Risk Premia
Hanno N. Lustig
UCLA - Anderson School of Management; National Bureau of Economic Research (NBER)
University of Southern California - Marshall School of Business
Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)
May 12, 2014
High interest rate currencies yield high currency excess returns on short-term Treasury bill investments, but they tend to yield low local excess returns on long-term government bonds. At longer maturities, the low term premium offsets the high currency risk premium. Under no arbitrage conditions, this exact result obtains when global permanent innovations to the pricing kernels of different countries are the same and therefore do not to have permanent effects on exchange rates. In this case, the uncovered interest rate parity holds at long horizons. We derive parametric restrictions to match the downward sloping term structure of carry trade risk premia in a large class of affine term structure models.
Number of Pages in PDF File: 82
Keywords: carry trade, UIP, currency risk premia, bond risk premia
Date posted: October 16, 2013
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