Carry Trades, Momentum Trading and Nonlinear Adjustments to Uncovered Interest Parity

This paper examines the role of recent currency trading strategies, known as carry trading and momentum trading and their implications for risk premium in the FX mar-ket. The risk premium arises from the forward premium anomaly, where the slope coef-cient in a regression of spot returns on the lagged interest rate di¤erential is negative and signi\u85cantly di¤erent to unity. The paper estimates Logistic Smooth Transition Dynamic Regression (LSTR) models with a variety of transition variables, including di¤erent carry trading interest rates and also volatility of spot rates associated with a momentum trading strategy. There is some evidence for the existence of an outer regime, that is consistent with uncovered interest parity holding when US interest rates exceed corresponding rates for the carry trade. There is conversely evidence for an inner regime that is consistent with the forward premium anomaly, where risk premia are statistically signi\u85cant