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

Christian Wagner

doi:10.1016/j.jimonfin.2012.01.013

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

Christian Wagner

Vienna University of Economics and Business

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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 language	English
Journal	Journal of International Money and Finance
Volume	31
Issue number	5
Pages (from-to)	1195–1219
Number of pages	25
ISSN	0261-5606
DOIs	https://doi.org/10.1016/j.jimonfin.2012.01.013
Publication status	Published - Sept 2012

Keywords

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

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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 {\textquoteleft}forward bias puzzle{\textquoteright} 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.",

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KW - Economic value

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KW - Uncovered interest parity

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KW - Carry-trade

KW - Economic value

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