Do Peso Problems Explain the Returns to the Carry Trade?
57 Pages Posted: 9 Jun 2008 Last revised: 1 Oct 2010
Date Written: June 2008
We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payoffs which are on average large and uncorrelated with traditional risk factors. We argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs.
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