The Returns to Currency Speculation

59 Pages Posted: 28 Dec 2006  

A. Craig Burnside

Duke University - Department of Economics; University of Glasgow - Department of Economics; National Bureau of Economic Research (NBER)

Martin Eichenbaum

Northwestern University; National Bureau of Economic Research (NBER)

Isaac Kleshchelski

Northwestern University

Sergio T. Rebelo

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR); University of Rochester - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2006

Abstract

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. The first strategy, known as the carry trade, is widely used by practitioners. This strategy involves selling currencies forward that are at a forward premium and buying currencies forward that are at a forward discount. The second strategy relies on a particular regression to forecast the payoff to selling currencies forward. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. However, these Sharpe ratios do not represent unexploited profit opportunities. In the presence of microstructure frictions, spot and forward exchange rates move against traders as they increase their positions. The resulting 'price pressure' drives a wedge between average and marginal Sharpe ratios. We argue that marginal Sharpe ratios are zero even though average Sharpe ratios are positive.

Suggested Citation

Burnside, A. Craig and Eichenbaum, Martin and Kleshchelski, Isaac and Rebelo, Sergio T., The Returns to Currency Speculation (October 2006). CEPR Discussion Paper No. 5883. Available at SSRN: https://ssrn.com/abstract=953924

Craig Burnside

Duke University - Department of Economics ( email )

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University of Glasgow - Department of Economics

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National Bureau of Economic Research (NBER)

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Martin Eichenbaum

Northwestern University ( email )

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United States
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National Bureau of Economic Research (NBER)

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Isaac Kleshchelski

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Sergio Tavares Rebelo (Contact Author)

Northwestern University - Kellogg School of Management ( email )

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Leverone Hall
Evanston, IL 60208
United States
847-467-2329 (Phone)
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Centre for Economic Policy Research (CEPR)

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University of Rochester - Department of Economics ( email )

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United States
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National Bureau of Economic Research (NBER)

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