Date of Submission

Spring 2013

Academic Program

Economics

Project Advisor 1

Alex Chung

Abstract/Artist's Statement

The existence of the forward premium puzzle and the corresponding violation of uncovered interest rate parity (UIP) give speculators in foreign exchange markets the opportunity to arbitrage similar interest rates in two different countries. Such a strategy, known as a carry trade, involves shorting a low-yielding currency in order to invest in a high-yielding one. Provided that UIP fails to hold, an absence of adverse exchange rate movements will allow an investor to earn the spread between the interest rates set by the central banks of the two countries in question. The presence of fairly liquid low- and high-yielding currencies in today’s FX markets serves to make carry trades particularly attractive. Given the strategy’s total dependence on exchange and interest rates, there are various financial and macroeconomic indicators that may serve useful in explaining its risk-return profile. This paper examines the predictive power of several such variables on excess returns in 3-month U.S. dollar-denominated carry trades for eight foreign currencies. Our data ranges from 1990 through the end of 2012 and is analyzed in three different segments. We conclude by constructing an aggregated model of our results in order to examine which of our variables are most helpful in studying these carry trades’ returns.

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