Carry Trades and Risk
Carry trades, in which an investor borrows a low interest rate currency and lends a high interest rate currency, have been profitable historically. The risk exposure of carry traders might explain their high returns, but conventional models of risk do not work because traditional risk factors, used to price the stock market, do not price currency returns. Less traditional factors that are more successful in explaining currency returns, are, however, unsuccessful in explaining the returns to the stock market. More exotic models of "crisis risk" are another possibility, but I show that any time-variation in the exposure of the carry trade to market risk has been insufficient, in sample, to explain the average returns earned by carry traders. Instead, peso events remain a candidate explanation of the returns to the carry trade.
I thank Martin Eichenbaum, Barry Rafferty, Sergio Rebelo, Nikolai Roussanov, Lucio Sarno and an anonymous referee for helpful comments. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.
“Carry Trades and Risk,” in Jessica James, Ian W. Marsh and Lucio Sarno, eds., Handbook of Exchange Rates. Hoboken: John Wiley & Sons, 2012.