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The Determinants of Carry Trade Risk Premia

Aidan Corcoran, Institute for International Integration Studies, Trinity College Dublin

Abstract

This paper tests a novel explanation for excess returns to the carry trade, namely, that investors are rewarded for exposure to equity risk of the target country. This risk factor is motivated via a hedging argument, whereby investors reallocate portfolio holdings to government debt in response to an increase in equity risk. Data from 1952 to 2007 on a broad sample of countries are used to test this hypothesis in an asset pricing framework which
controls for global equity returns, exchange rate volatility, and global consumption factors. Target currency equity returns are found to be a priced risk factor after controlling for these factors. Implications for the diversi cation of international portfolio risk are discussed.

Keywords:

uncovered interest parity, exchange rates, carry trade.

JEL No.:

G12, G15, F31


Last updated 28 August 2014 by IIIS (Email).