Carry trade returns and segmented risk pricing

The carry trade strategy, which exploits the forward premium puzzle, shows a persistent outperformance compared to a passive benchmark strategy, even on a risk-adjusted basis. So far, the literature has not come up with a consistent explanation and controversially discusses a risk-based approach as well as peso problems and crash risk. This paper introduces a different view and examines if carry trade returns could be explained by persistent differences in risk pricing between single carry trade countries. The analysis covers U.S. dollar, Japanese yen, Swiss franc, Australian dollar and New Zealand dollar with data from 2000 to 2017. Firstly, based on the consumption model, I relate the country interest rate under uncertainty to the first and second moment of domestic consumption growth and test for different country risk aversion. With data of private final consumption and deposit rates, I find large and persistent differences in country risk aversion of dominant carry trade currencies. Thereby, investment currencies are more sensitive to U.S. consumption risk, while funding currencies provide a hedge. Secondly, I test for the country market implied risk aversion based on option-implied and realized volatility. With data of respective country stock market indices under a generalized method of moments estimation, I could not find large differences in market implied country risk aversion of dominant carry trade currencies. The country interest rate differential, respectively the forward premium, constitutes a leading part in the carry trade performance. Thus, persistent differences in country risk aversion seem to offer a risk-based explanation of carry trade returns. However, this also implies that there is no unifying pricing kernel and, consequently, the interest rate market and equity market are segmented in risk pricing for dominant carry trade currencies.