WHAT CARRIES THE CARRY TRADE? First Draft: October 2008 This Draft: May 2009

We build a partial equilibrium model to explain the carry trade and its eventful unwinding. We treat the foreign currency from a pure \u85nancial asset point of view. Collateral capacity of the carry trade positions entices traders to enter the speculation in our model and causes the deviation from the uncovered interest parity. We theorize that the leverage cycle is one possible source of the time-varying risk premium for holding the foreign currency. Empirically, we support our model prediction by showing that the carry trade is pervasive as the market-wide credit spread reverts to its long-run mean and that the carry trade unwinds when the credit spread is exogenously spiked. JEL classi\u85cation: F3