DP5883 The Returns to Currency Speculation

Author(s): A Craig Burnside , Martin Eichenbaum , Isaac Kleshchelski , Sérgio Rebelo

Publication Date: October 2006

Keyword(s): uncovered interest parity , exchange rates , carry trade

JEL(s): F31

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP5883.asp.asp

Currencies that are at a forward premium tend to depreciate. This ‘forward-premium puzzle’ represents an egregious deviation from uncovered interest parity. We document the properties of returns to currency speculation strategies that exploit this anomaly. The first strategy, known as the carry trade, is widely used by practitioners. This strategy involves selling currencies forward that are at a forward premium and buying currencies forward that are at a forward discount. The second strategy relies on a particular regression to forecast the payoff to selling currencies forward. We show that these strategies yield high Sharpe ratios which are not a compensation for risk. However, these Sharpe ratios do not represent unexploited profit opportunities. In the presence of microstructure frictions, spot and forward exchange rates move against traders as they increase their positions. The resulting ‘price pressure’ drives a wedge between average and marginal Sharpe ratios. We argue that marginal Sharpe ratios are zero even though average Sharpe ratios are positive.