Cyclical and Persistent Carry Trade Returns and Forward Premia

Abstract

We show that carry trade excess returns and forward premia of exchange rates possess persistent and clear business-cycle patterns. Our results contradict the peso model of hedged carry trade developed by [Burnside, C., M. Eichenbaum, I. Kleshchelski, and S. Rebelo, 2011, Do Peso Problems Explain the Returns to the Carry Trade?, Review of Financial Studies 24(3), 853–891.] and the overcon¯dence model of carry trade developed by [Burnside, C., B. Han, D. Hirshleifer, and T. Y. Wang, 2011, Investor Overcon¯dence and the Forward Premium Puzzle, Review of Economic Studies 78(2), 523–558.]. Our results support equilibrium asset pricing models and share the habit formation view of [Verdelhan, A., 2010, A Habit-Based Explanation of the Exchange Rate Risk Premium, Journal of Finance 65(1), 123–145.] that requires countercyclical risk premia. In bad times, when risk aversion is high and domestic interest rates are low, investors require positive currency excess returns. Consistent with [Lustig, H., N. Roussanov, and A. Verdelhan, 2014, Countercyclical Currency Risk Premia, Journal of Financial Economics 111(3), 527–553.] the cyclicality of excess returns is associated with the cyclicality of forward premia. We ¯nd that the persistence in forward premia and excess returns is related to their cyclicality. Our results are robust to the [Lustig, H., N. Roussanov, and A. Verdelhan, 2011, Common Risk Factors in Currency Market, Review of Financial Studies 24(11), 3731–3777; Lustig, H., N. Roussanov, and A. Verdelhan, 2014, Countercyclical Currency Risk Premia, Journal of Financial Economics 111(3), 527–553.] highminus-low (HML) and \dollar carry trade" portfolios