Leveraging Excess Return: The Carry Trade and the Consumption-based Capital Asset Pricing Model

Open Access
Author:
Kearns, Joseph Gilbert
Area of Honors:
Economics
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • Alessandro Dovis, Thesis Supervisor
  • Russell Paul Chuderewicz, Honors Advisor
Keywords:
  • Exchange Rates
  • International Finance
  • Interest Rate Parity
  • Asset Pricing
  • Carry Trade
Abstract:
In this thesis, I investigate the violation of uncovered interest rate parity in the foreign exchange market. Bias in the pricing of forward exchange rates relative to future spot exchange rates suggests there are profitable opportunities in the spot market. The carry trade is an investment strategy in which an investor borrows in a low interest rate currency and invests the proceeds in an asset denominated in a high interest rate currency like a certificate of deposit, government bond, or equity share. The positive excess returns generated by carry trades for many exchange rates in this paper contradict the uncovered interest rate parity condition. This paper uses a variant of the Consumption-Based Capital Asset Pricing Model (C-CAPM) articulated by John Cochrane to assess the predictability of carry trade excess returns. Ordinary least squares and robust regressions show that the magnitude of C-CAPM’s ability to explain variation in excess returns can be strong in certain time periods, but is time-varying in general. A fixed effects univariate panel regression more clearly demonstrates that the excess returns for all of the funding currencies can have between 45% and 76% of their variation over explained by C-CAPM. The model also explains a substantial percentage of the variation in carry trades going long on one-year government bonds and large cap equity indices. The results of this paper suggest that excess returns of the carry trade are forecastable with C-CAPM, but the strength of the model’s forecasting power varies across countries and time.