Risk-Premia, Carry-Trade Dynamics, and Economic Value of Currency Speculation

Abstract

In this paper, we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range. We show that exchange rate returns comprise a time-varying risk-premium and that uncovered interest parity (UIP) holds in a speculative sense. The often-cited 'forward bias puzzle' originates from the omission of the risk-premium in standard UIP tests. Consistent with its popularity among market professionals, the carry-trade strategy can be rationalized as it systematically collects risk-premia and generates economic value when applied in multi-currency portfolios.

Standard and optimized carry trades

“…An extensive literature documents that standard carry trades historically provide an excess return (Burnside, ; Clarida, Davis, & Pedersen, ; Darvas, ; Jylhä & Suominen, ; Wagner, ). The positive return is built on the failure of the UIP.…”