The Term Structure of Currency Carry Trade Risk Premia

Abstract

We find that average returns to currency carry trades decrease significantly as the maturity of the foreign bonds increases, because investment currencies tend to have small local bond term premia. The downward term structure of carry trade risk premia is informative about the temporal nature of risks that investors face in currency markets. We show that long-maturity currency risk premia only depend on the domestic and foreign permanent components of the pricing kernels, since transitory currency risk is automatically hedged by interest rate risk for long-maturity bonds. Our findings imply that there is more cross-border sharing of permanent than transitory shocks.

'Superstitious' Investors

“…Note that, unlike previous results, the one-period nature of the forward-premium regressions implies that we need not specify a process for x jt . Bringing in term structure information, such as in Lustig et al (2018), would help pin down such a process. We leave such extensions to future work.…”

“…For the data panel, t-statistics are adjusted for heteroskedasticity and autocorrelation.Panel A of the table reports means and standard deviations of average log excess currency returns rx and log forward discount f − s within each of 6 currency portfolios formed on the forward discount. Data, fromLustig et al (2011Lustig et al ( ), are monthly, from 1983Lustig et al ( -2018. Panel B reports the 50th percentiles of those moments over 1000 simulations of the model, each with 293 monthly observations.Figure 1: Log Real Dividend and Log Real Price Level of the Aggregate Market, Full Sample…”

From carry trades to curvy trades

“…Building currency portfolios based on prospective exchange rate movements yields return distributions which are less skewed and thus less subject to tail risks. In this way, we also add to the related literature that rationalises the salient feature of negative return skewness with the stronger sensitivity of high interest rate currencies to FX volatility, and, to a lesser extent, liquidity constraints and commodity prices (Bakshi & Panayotov, ; Della Corte, Riddiough, & Sarno, ; Lustig, Roussanov, & Verdelhan, ; Lustig, Stathopoulos, & Verdelhan, ; Menkhoff, Sarno, Schmeling, & Schrimpf, ). With the return distribution being broadly symmetric, excess returns of curvy trade portfolios cannot be explained by observable risk factors—an assessment that is confirmed in a linear asset pricing framework.…”