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)
We find that average returns to currency carry trades decrease significantly as the maturity of the foreign bonds increases, because investment currencies tend to have small local bond term premia. The downward term structure of carry trade risk premia is informative about the temporal nature of risks that investors face in currency markets. We show that long-maturity currency risk premia only depend on the domestic and foreign permanent components of the pricing kernels, since transitory currency risk is automatically hedged by interest rate risk for long-maturity bonds. Our findings imply that there is more cross-border sharing of permanent than transitory shocks.
Number of Pages in PDF File: 74
Keywords: carry trade, UIP, currency risk premia, bond risk premiaworking papers series
Date posted: October 16, 2013 ; Last revised: November 25, 2013
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