Carry Trade Returns and Segmented Risk Pricing
24 Pages Posted: 23 Feb 2018 Last revised: 12 Jul 2019
Date Written: July 10, 2019
The returns to carry trades are controversially discussed as there seems to be no unifying risk-based explanation of currency returns and stock returns. This paper addresses carry trade returns from a risk pricing perspective and examines if these returns can be connected to persistent cross-country differences of risk aversion. Therefore, I analyze a data set of individual carry trade currencies. Based on a GMM estimation, I find significantly large and persistent cross-country differences of risk aversion in the interest rate market compared to the implied risk aversion in the stock market. In this context, investment currencies are more sensitive to U.S. consumption risk while funding currencies provide a hedge. However, this also implies that there is no unifying SDF and consequently, both the interest rate market and the stock market appear to be segmented in risk pricing for carry trade countries.
Keywords: currency returns, foreign exchange, forward premium puzzle, risk aversion, stochastic discount factor
JEL Classification: E21, F31, G12
Suggested Citation: Suggested Citation