The Currency Carry Trade and Subjective Expectations
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Abstract
Using survey-based forecasts, we construct measures of subjective return expectations for the currency carry trade and uncover systematic forecast errors in both the exchange rate and interest rate components. The evidence on forecast error dynamics points towards extrapolative beliefs. In addition, we find a negative correlation between return expectations and contemporaneous exchange rate movements, as well as a positive correlation with net bond inflows at the currency level, consistent with the idea that return expectations for the carry trade contribute to currency demand. We also document patterns in conditional correlation between expected currency appreciation and subsequent exchange rate movements, and link those results to a related evidence on forecast errors.