Currency Puzzles and the Oil Connection

Abstract

Several long-standing currency puzzles have been reversed in recent years, including the forward premium puzzle, carry trade profitability, and the exchange rate ``disconnect''. We provide a common framework for understanding these reversals, which relies on the structural breaks found in currency returns in 2005, and on a concurrent shift in the relative importance of global and local currency risk factors. We associate this shift with the growth in the U.S. oil sector, stronger impact of the oil price on U.S. inflation, and weaker link between the real interest rates in the U.S. and other advanced economies since 2005.

Keywords: currency market models, currency carry trades

JEL Classification: F31, G12, G15