Salvaging the C-Capm: Currency Carry Trade Risk Premia and Conditioning Information

Abstract

We use a standard consumption-based asset pricing model incorporating conditioning information to explain the risk-return profile of currency carry trade portfolios. We use a scaled stochastic discount factor instead of scaled or managed portfolio returns as in previous work. Our conditioning variable is a forward-looking measure of net foreign assets. It arises from an intertemporal budget constraint and has predictive power for exchange rates. We find that our conditional consumption-CAPM is able to price a large part of the variation in cross-section of carry trade portfolios using cross-sectional as well as time series regression-based tests. Taken together, our results imply that the consumption-based models do still have a role to play in explaining excess returns on carry trade strategies.

Keywords: Consumption CAPM, Fama-MacBeth Regressions, Net Foreign Assets, Conditioning Information, Conditional Asset Pricing Models

JEL Classification: G0, G10, G12