Risk-Premia, Carry-Trade Dynamics, and Economic Value of Currency Speculation
39 Pages Posted: 11 Sep 2006 Last revised: 25 Aug 2009
Date Written: March 1, 2008
In this paper, we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range. We show that exchange rate returns comprise a time-varying risk-premium and that uncovered interest parity (UIP) holds in a speculative sense. The often-cited 'forward bias puzzle' originates from the omission of the risk-premium in standard UIP tests. Consistent with its popularity among market professionals, the carry-trade strategy can be rationalized as it systematically collects risk-premia and generates economic value when applied in multi-currency portfolios.
Keywords: Exchange rates, Uncovered interest parity, Forward bias puzzle, Risk-premia, Carry-trade, Economic value
JEL Classification: F31
Suggested Citation: Suggested Citation