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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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10.1 Introduction

In a foreign exchange carry trade, an investor borrows funds in a low interest rate currency and lends those funds in a high interest rate currency. The uncovered interest parity (UIP) condition states that the interest rate differential between riskless assets denominated in foreign and domestic currency is equal to the rate at which the foreign currency is expected to depreciate against the domestic currency. If the UIP condition held, an investor engaged in the carry trade would, therefore, expect a zero net payoff. One motivation for investors to engage in the carry trade is, however, that UIP does not appear to hold in the data.1 If anything, high interest rate currencies are more likely to appreciate than depreciate against low interest rate currencies. Consequently, in historical data, carry trades have earned positive average returns in excess of the interest differentials between the relevant currencies.

If investors expect to earn the interest differential, why do they limit their trading in foreign exchange? The most obvious explanation is that carry trades are risky, and that the average returns to carry trades reflect a risk premium. In this chapter, I review the evidence for and against a variety of risk-premium-based explanations. I first explore traditional factor models, ones that have been used to explain the returns to stock market portfolios. Examples include the CAPM, the Fama–French three-factor model, and the consumption CAPM. I find that ...

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