10. Carry Trades and Risk

  1. Jessica James,
  2. Ian W. Marsh3 and
  3. Lucio Sarno3,4
  1. Craig Burnside1,2,4

Published Online: 8 OCT 2012

DOI: 10.1002/9781118445785.ch10

Handbook of Exchange Rates

Handbook of Exchange Rates

How to Cite

Burnside, C. (2012) Carry Trades and Risk, in Handbook of Exchange Rates (eds J. James, I. W. Marsh and L. Sarno), John Wiley & Sons, Inc., Hoboken, NJ, USA. doi: 10.1002/9781118445785.ch10

Editor Information

  1. 3

    Cass Business School, London, UK

  2. 4

    CEPR, UK

Author Information

  1. 1

    Department of Economics, Duke University, Durham, NC, USA

  2. 2

    NBER, USA

  3. 4

    CEPR, UK

Publication History

  1. Published Online: 8 OCT 2012
  2. Published Print: 14 JUN 2012

ISBN Information

Print ISBN: 9780470768839

Online ISBN: 9781118445785

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Keywords:

  • carry trades;
  • foreign exchange;
  • peso problems;
  • rare events;
  • time-varying risk

Summary

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. This chapter reviews the evidence for and against a variety of risk-premium-based explanations. It begins with the definition of carry trade, and discusses the measurement of the returns to two carry trade portfolios in historical data. Next, it shows the derivation of theoretical pricing equations for risk-based explanations, and outlines the empirical methods used for assessing them. This is followed by the presentation of the empirical results. Then, time-varying risk, rare events, and peso problems are discussed.

Controlled Vocabulary Terms

carry trades; foreign exchange markets; peso event risk; rare events; time-varying risk