Discussion Papers on Economics,
University of Southern Denmark, Department of Economics

Abstract: Dollar carry trade risk premiums – unlike dollar-neutral or foreign exchange carry risk premiums – are positively correlated with firm-level dispersions in investment, profitability, and book-to-market in addition to the Treasury-bill rate, long term bond yield, term spread, and default spread. Several forecasting models pin down the few periods responsible for the entire premium, based on these proxies for the latent risk and price of risk states in the U.S. (and its business cycle). This predictability is also statistically and economically significant out of sample: It generates Sharpe ratios as large as 1.37 (compared to 0.44 unconditionally), for example.

Keywords: Carry trade; risk premium; business cycle; microeconomic dispersion; foreign exchange

JEL-codes: D25; E32; F31; G11; G12; G15

74 pages, October 21, 2020

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