Do Peso Problems Explain the Returns to the Carry Trade?
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 argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs.
This paper is a substantially revised version of NBER Working Paper 12489 titled "The Returns to Currency Speculation." We thank the editor, Geert Bekaert, two anonymous referees, John Cochrane, John Heaton, Jakub Jurek, and Ravi Jagannathan for very useful comments. We also thank the Chicago Mercantile Exchange for providing us with the currency-options data used in this paper. Burnside is grateful to the National Science Foundation for financial support (SES-0516697). The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2011. "Do Peso Problems Explain the Returns to the Carry Trade?," Review of Financial Studies, Society for Financial Studies, vol. 24(3), pages 853-891. citation courtesy of