Do Peso Problems Explain the Returns to the Carry Trade?

Abstract

We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies.This strategy generates payoffs which 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.

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