#5 – FX Carry Trade

Authors: Maurer, To, Tran

Title: Pricing Risks Across Currency Denominations

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2589545

Abstract:

Investors based in different countries earn different returns on same strategies because the same risks covary differently with countries' stochastic discount factors (SDFs). We document that investors in low-interest-rate countries earn more than those in high-interest-rate countries on identical carry trade strategies. We propose a novel econometric procedure to estimate country-specific SDFs from foreign exchange market data. We provide out-of-sample evidence that (i) a country's interest rate is inversely related to its SDF volatility, (ii) output gap fluctuations across countries strongly correlate with estimated SDFs, and (iii) our estimated SDFs explain half of the risk in equity markets as measured by priced equity premia.

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