Do peso problems explain the returns to the carry trade?
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We study the properties of the carry trade, a currency speculation strategy in which an investor borrows low-interest-rate currencies and lends high-interest-rate currencies. This strategy generates payoffs that are on average large and uncorrelated with traditional risk factors. We argue that these payoffs reflect a peso problem. The underlying peso event features high values of the stochastic discount factor rather than very large negative payoffs. © 2010 The Author Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved.