Do Peso Problems Explain the Returns to the Carry Trade

We study the properties of the carry trade, a currency speculation strategy in which an in-vestor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payoffs that are on average large and uncorrelated with traditional risk factors. We argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs. (JEL F31) The forward exchange rate is a biased forecaster of the future spot exchange rate. This fact is often referred to as the “forward-premium puzzle. ” We study the properties of a widely used currency speculation strategy, known as the carry trade, which exploits this puzzle. This strategy involves selling curren-cies forward that are at a forward premium and buying currencies forward that are at a forward discount. Transaction costs aside, this strategy is equiva-lent to borrowing low-interest-rate currencies in order to lend high-interest-rate currencies, without hedging the associated currency risk. Consistent with re-sults in the literature, we find that the carry trade strategy applied to portfolios of currencies yields high average payoffs, as well as Sharpe ratios that are substantially higher than those associated with the U.S. stock market. This article is a substantially revised version of NBER Working Paper 12489, titled “The Returns to Currenc