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)
March 1, 2015
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. In the absence of arbitrage opportunities, this exact result obtains when the martingale components of the pricing kernels are the same across countries. In this case, exchange rates are stationary and 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 multi-country affine term structure models.
Number of Pages in PDF File: 84
Keywords: carry trade, UIP, currency risk premia, bond risk premia
Date posted: October 16, 2013 ; Last revised: March 28, 2015
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