Carry Trade: Beyond the Forward Premium Puzzle

We show that the Carry Trade exploits a static interest rate differential which is largely unrelated to the fact that currencies whose interest rates exceed their long-run average tend to appreciate (the Forward Premium Puzzle). The evidence is consistent with the presence of a static risk premium: investors are permanently more averse to being exposed to the exchange rate risk associated with particular countries. However, we find no evidence that bilateral currency risk premia vary over time. Instead, the forward premium puzzle is a statistical correlation that does not predict economic returns. We show that abnormal returns in foreign exchange markets can be explained in a parsimonious model in which there are permanent differences in the cross-section of currency risk premia and all currency risk premia against the US Dollar move together over time.