Do Peso Problems Explain the Returns to the Carry Trade?

74 Pages Posted: 20 Aug 2008

See all articles by A. Craig Burnside

A. Craig Burnside

Duke University - Department of Economics; University of Glasgow - Department of Economics; National Bureau of Economic Research (NBER)

Martin Eichenbaum

Northwestern University; National Bureau of Economic Research (NBER)

Isaac Kleshchelski

Northwestern University

Sergio T. Rebelo

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: June 2008

Abstract

Currencies that are at a forward premium tend to depreciate. This `forward-premium puzzle' is an egregious deviation from uncovered interest parity. We document the properties of the carry trade, a currency speculation strategy that exploits this anomaly. This strategy consists of borrowing low-interest-rate currencies and lending high-interest-rate currencies. We first show that the carry trade yields a high Sharpe ratio that is not a compensation for risk. We then consider a hedged version of the carry trade, which protects the investor against large, adverse currency movements. This strategy, implemented with currency options, yields average payoffs that are statistically indistinguishable from the average payoffs to the standard carry trade. We argue that this finding implies that the peso problem cannot be a major determinant of the payoff to the carry trade.

Keywords: carry trade, exchange rates, Uncovered interest parity

JEL Classification: F31

Suggested Citation

Burnside, Craig and Eichenbaum, Martin and Kleshchelski, Isaac and Tavares Rebelo, Sergio, Do Peso Problems Explain the Returns to the Carry Trade? (June 2008). CEPR Discussion Paper No. DP6873. Available at SSRN: https://ssrn.com/abstract=1240183

Craig Burnside (Contact Author)

Duke University - Department of Economics ( email )

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

University of Glasgow - Department of Economics

Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Martin Eichenbaum

Northwestern University ( email )

2003 Sheridan Road
Evanston, IL 60208
United States
847-491-8232 (Phone)
847-491-7001 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Isaac Kleshchelski

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Sergio Tavares Rebelo

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Leverone Hall
Evanston, IL 60208
United States
847-467-2329 (Phone)
847-491-5719 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
5
Abstract Views
662
PlumX Metrics