The Term Structure of Currency Carry Trade Risk Premia

The Term Structure of Currency Carry Trade Risk Premia

By Hanno Lustig, Andreas Stathopoulos, Adrien Verdelhan
October 2017Working Paper No. 3411

Fixing the investment horizon, the returns to currency carry trades decrease as the maturity of the foreign bonds increases, because the local currency term premia offset the currency risk premia. The time series predictability of foreign bond returns in dollars similarly declines as the maturity of the bonds increases. Leading no-arbitrage models in international finance cannot match the downward term structure of currency carry trade risk premia. While currency risk premia on short-term bonds reflect differences in transitory and permanent risk, we show that the premia on long-term bonds only reflect differences in the risk of permanent shocks to investors’ marginal utility.

Keywords
exchange rate stationarity, carry trade, UIP, currency risk premia, bond risk premia