Risk-premia, Carry-trade Dynamics, and Economic Value of Currency Speculation

Christian Wagner

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    Abstract

    In this paper, we derive the dynamics and assess the economic value of currency speculation by formalizing the concept of a trader inaction range. We show that exchange rate returns comprise a time-varying risk-premium and that uncovered interest parity (UIP) holds in a speculative sense. The often-cited ‘forward bias puzzle’ originates from the omission of the risk-premium in standard UIP tests. Consistent with its popularity among market professionals, the carry-trade strategy can be rationalized as it systematically collects risk-premia, however, the economic value generated by bilateral carry-trades is limited.
    Original languageEnglish
    JournalJournal of International Money and Finance
    Volume31
    Issue number5
    Pages (from-to)1195–1219
    Number of pages25
    ISSN0261-5606
    DOIs
    Publication statusPublished - Sep 2012

    Keywords

    • Exchange rates
    • Uncovered interest parity
    • Risk-premia
    • Carry-trade
    • Economic value

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