A1 - Virginie Coudert

A1 - Valérie Mignon

TI - The “Forward Premium Puzzle” and the Sovereign Default Risk

IS - 2011-17

T3 - Working Papers

KW - Carry trades

KW - Forward premium

KW - UIP puzzle

KW - Default risk

KW - Smooth transition regression models

N2 - Carry-trade strategies which consist of buying forward high-yield currencies tend to generate positive excess returns during long periods of time. Here, we aim at explaining this puzzle by the default risk, which is frequently taken on by investing in high-yield currencies. We empirically test for this hypothesis on a sample of 18 emerging currencies over the period from June 2005 to September 2010, the default risk being proxied by the sovereign credit default swap spread. Relying on smooth transition regression models, we show that default risk fuels the carry-trade gains during periods of upbeat financial markets, and worsens the losses in bear markets. We then introduce the default risk into the “Fama regression” linking the exchange-rate depreciation to the interest-rate differential. The “forward bias”, usually evidenced by a coefficient smaller than unity in this regression, is somewhat alleviated, as the default risk partially explains the excess return.

ER -