The Term Structure of Currency Carry Trade Risk Premia

Abstract

Fixing the investment horizon, the returns to currency carry trades decrease as the maturity of the foreign bonds increases. Across developed countries, the local currency term premia, which increase with the maturity of the bonds, offset the currency risk premia. Similarly, in the time-series, the predictability of foreign bond returns in dollars declines with the bonds’ maturities. Leading no-arbitrage models in international finance do not match the downward term structure of currency carry trade risk premia. We derive a simple preference-free condition that no-arbitrage models need to reproduce in the absence of carry trade risk premia on long-term bonds. (JEL E43, G12, G15)

Taking the Cochrane-Piazzesi Term Structure Model Out of Sample: More Data, Additional Currencies, and FX Implications

“…Once again, for completeness we present the results for the NOK, but because the NOK sample ending in 2003 is particularly short, we do not interpret them.12 See Daniel, Hodrick and Lu (2017) for a recent review of the literature on the risks of the carry trade at the monthly holding period horizon Lustig, Stathopoulos and Verdelhan (2017). find that investing in the carry trade with longer term bonds while maintaining the one-month holding period is unattractive as the term premiums offset the currency premiums.…”

Conditional Dynamics and the Multi-Horizon Risk-Return Trade-Off

“…Our paper makes a connection with a literature that seeks to characterize multihorizon properties of "zero-coupon" assets, such as bonds, dividends strips, variance swaps, and currencies. Such work includes Backus, Boyarchenko, and Chernov (2018), Belo, Collin-Dufresne, and Goldstein (2015), van Binsbergen, Brandt, and Koijen (2012), Dahlquist and Hasseltoft (2013), Dew-Becker, Giglio, Le, and Rodriguez (2015), Hansen, Heaton, and Li (2008), Koijen, Lustig, and Nieuwerburgh (2017), Lustig, Stathopoulos, and Verdelhan (2013), and Zviadadze (2017).…”

The term structure of exchange rate predictability: Commonality, scapegoat, and disagreement

“…If domestic risk-free rate is greater (less) than foreign risk-free rate, c (τ ) t+τ is the (reverse) carry trade excess return of investing in USD funded by foreign currency. Lustig, Stathopoulos, and Verdelhan (2013) reveal that the term structure of carry trade risk premia is downward sloping because investment currencies tend to have low local sovereign term premia relative to funding currencies. Given that the forward premium component is already known at time t, exchange rate predictability originates from the carry trade risk premium component, which is driven by latent term structure factors.…”

“…Given that the higher yield currencies tend to have lower local sovereign term premia than the lower yield currencies (Lustig, Stathopoulos, and Verdelhan, 2013), we are able to employ a term structure model to fit the the risk premium component of exchange rate returns via decomposition, which generalizes exchange rate models for different forecasting horizons. This generalization process differentiate the loadings on the latent factors that drive the exchange rate over a range of modeling horizons.…”

“…One main contribution of our research is that we are the first to investigate the term structure of exchange rate predictability by decomposing exchange rate returns into carry trade risk premia and forward premium components. Lustig, Stathopoulos, and Verdelhan (2013) theoretically derive that the term structure of carry trade risk premia (excess return) is downward sloping because investment currencies tend to have low local sovereign term premia relative to funding currencies. We focus on the term structure of excess return component, from which the predictability origins and by which an exchange rate model is generalized.…”