Solvency Risk Premia and the Carry Trades
50 Pages Posted: 23 Feb 2016 Last revised: 6 Nov 2017
Date Written: October 1, 2017
This paper shows that currency carry trades can be rationalized by the time-varying risk premia originating from the sovereign solvency risk. We find that solvency risk is a key determinant of risk premia in the cross section of carry trade returns, as its covariance with returns captures a substantial part of the cross-sectional variation of carry trade returns. Importantly, low interest rate currencies serve as insurance against solvency risk, while high interest rate currencies expose investors to more risk. The results are not attenuated by existing risks and pass a broad range of various robustness checks.
Keywords: Solvency; Carry Trades; Risk Premia
JEL Classification: F31, G15
Suggested Citation: Suggested Citation