61 Pages Posted: 1 Dec 2006
Date Written: August 2006
Currencies that are at a forward premium tend to depreciate. This 'forward-premium puzzle' represents an egregious deviation from uncovered interest parity. We document the properties of returns to currency speculation strategies that exploit this anomaly. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. In practice bid-ask spreads are an increasing function of order size. In addition, there is price pressure, i.e. exchange rates are an increasing function of net order flow. Together these frictions greatly reduce the profitability of currency speculation strategies. In fact, the marginal Sharpe ratio associated with currency speculation can be zero even though the average Sharpe ratio is positive.
Suggested Citation: Suggested Citation
Burnside, A. Craig and Eichenbaum, Martin and Kleshchelski, Isaac and Rebelo, Sergio T., The Returns to Currency Speculation (August 2006). NBER Working Paper No. w12489. Available at SSRN: https://ssrn.com/abstract=927212
By Karen Lewis