88 Pages Posted: 16 Oct 2013 Last revised: 6 Sep 2017
Date Written: August 2017
Fixing the investment horizon, the returns to currency carry trades decrease as the maturity of the foreign bonds increases, because the local currency term premia offset the currency risk premia. The time series predictability of foreign bond returns in dollars similarly declines as the maturity of the bonds increases. Leading no-arbitrage models in international finance cannot match the downward term structure of currency carry trade risk premia. We show that currency risk premia on short-term bonds reflect differences in transitory and permanent risk, while the premia on long-term bonds only reflect differences in the risk of permanent shocks to investors' marginal utility. To guide future work, we derive a novel, preference-free condition for dynamic asset pricing models: shocks to the quantity or price of risk cannot impact marginal utility and hence exchange rates in the long run.
Keywords: exchange rate stationarity, carry trade, UIP, currency risk premia, bond risk premia
Suggested Citation: Suggested Citation
Lustig, Hanno N. and Stathopoulos, Andreas and Verdelhan, Adrien, Nominal Exchange Rate Stationarity and Long-Term Bond Returns (August 2017). Available at SSRN: https://ssrn.com/abstract=2340547 or http://dx.doi.org/10.2139/ssrn.2340547
By Karen Lewis