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This paper focuses on emerging market government bonds issued in local currency with different maturities. Foreign investors face interest rate, currency, and credit risks. We consider the entire term structure of carry trade returns and find that, while the default premium does not contribute to carry trade strategies, the contribution of interest rate risk, captured by the term premium, is large and increases with maturity. We introduce default risk in an otherwise standard affine model; we show that the volatility of the permanent component of the SDFs must be different across emerging markets in order to match these stylized facts. (JEL F31, F34, G15) Received September 9, 2019; editorial decision March 25, 2021 by Editor: Nikolai Roussanov. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

This study empirically examines the effect of foreign exchange (FX) market liquidity risk and volatility on the excess returns of currency carry trades. In contrast to the existent literature, we construct an alternative proxy of liquidity risk - violations of no arbitrage bounds in the forward and currency swap markets. We also use volatility smile data to capture FX-market specific volatility. The sample data cover periods both before and after the Global Financial Crisis (GFC). Both proxies are significant in explaining the abnormal returns of carry trades, particularly after the GFC. Our findings provide substantial evidence that uncovered interest parity (UIP) puzzle can be resolved after controlling for liquidity risk and market volatility.

© 2016 The Author 2016. Published by Oxford University Press on behalf of The Society for Financial Studies. We show that a global imbalance risk factor that captures the spread in countries' external imbalances and their propensity to issue external liabilities in foreign currency explains the cross-sectional variation in currency excess returns. The economic intuition is simple: net debtor countries offer a currency risk premium to compensate investors willing to finance negative external imbalances because their currencies depreciate in bad times. This mechanism is consistent with exchange rate theory based on capital flows in imperfect financial markets. We also find that the global imbalance factor is priced in cross-sections of other major asset markets.

Lower-interest-rate currencies tend to depreciate relative to higher-interest-rate currencies. This observation is inconsistent with a popular theory, uncovered interest parity (UIP). According to market participants' views, this is caused by the carry-trade activities in a low-volatility environment. This paper investigates how exchange rate volatilities influence the failure of UIP by using a regime-switching model, which is less restricted than those used in the literature. We estimate this model using a new method of Bayesian Gibbs sampling, which enables us to examine higher-frequency state transmissions and, at the same time, avoid possible estimation biases arising from the use of overlapping data. The main findings are as follows. First, statistical tests support our model in comparison with the alternatives. The evidence suggests that regime switches in exchange rate returns should be interpreted as switches in the relationship between the returns and interest rate differentials, which may be interpreted as switches between the carry trade and its unwinding. Second, low-interest-rate currencies appreciate less frequently, but once it occurs, its movement is faster than when they depreciate. This may be because the appreciation is influenced by a rapid unwinding of the carry trade. Third, a low volatility tends to cause UIP failure. In fact, the reverse is also true. That is, UIP failure contributes to maintaining a lower-volatility environment, which may imply that a high volatility does not tend to occur until an unwinding of the carry trade. These results imply that the low-volatility environment and UIP failure are mutually dependent. Finally, the second and third findings are more evident for shorter maturities, and this may imply that UIP failure is influenced by short-term speculations. All these results are consistent with market participants' views: the short-term carry trade in a low-volatility environment and its rapid unwinding substantially influence exchange rates.