We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payoffs which are on average large and uncorrelated with traditional risk factors. We investigate whether these payoffs reflect a peso problem. We argue that, with one proviso, they do. The proviso is that the defining characteristic of a peso event is a high value of the stochastic discount factor, not high carry-trade losses. We reach this conclusion by analyzing the payoffs to the hedged carry trade, in which an investor uses currency options to protect himself from the downside risk from large, adverse movements in exchange rates. We find that the same value of the stochastic discount factor that rationalizes the average payoffs to the carry trade also rationalizes the equity premium.
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This paper was revised on October 15, 2008
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